Living on the margin: Optimizing collateral for OTC derivatives

In the post-financial crisis environment, the nature of collateral and liquidity management has changed dramatically. Once a simple operational process, it is now a risk-based process in which counterparties exchange collateral with an eye on the liquidity risk it creates.

“Because of regulatory changes, more firms are posting collateral,” says Phil McCabe, Global Head of Product for Bloomberg’s collateral management solution. “Local regulators now specify the types of collateral they consider ‘high quality’ and therefore eligible to post. Collateral management has turned into much more of an optimization process that involves careful valuation and assessment of the collateral position.”

Globally, financial regulators aim to improve transparency in the derivatives markets. The European Market Infrastructure Regulation (EMIR), for example, introduced margin requirements for uncleared derivatives. Counterparties that are in scope must exchange margin on over the counter (OTC) derivatives contracts that are not cleared through a central counterparty.

Two types of margin are required: Variation, which covers current exposure and is calculated using a mark to market position, and initial, which covers potential future exposure for the expected time between the last variation margin exchange and official recognition of the default of a counterparty.

The requirements, introduced in 2016-2017 for thousands of firms globally, will be phased-in through 2020, eventually requiring all firms holding $8 billion or more of non-cleared derivatives to make complex margin calculations, and to think carefully about the resulting liquidity risk.

Research conducted at Bloomberg’s recent Risk Day event in London found that there is no consensus on the biggest pain point in meeting the stricter initial and variation margin requirements. Of the 55 risk professionals surveyed, the most common response was “daily operational issues.” Other concerns included fragmentation of their front, middle and back office operations, a lack of timely, quality data, and re-papering/renegotiation of contracts. Of least concern was the cost of updating existing technology.

When asked how the new variation margin rules for OTC derivatives affect their opinion of the asset class for the buy-side, nearly half of the risk professionals said that margin rules make it less attractive, while 36 percent said the margin rules had no impact on their perception of the asset class. Only a few said the margin rules made the OTC derivatives asset class more attractive.

Opinion was also divided as to how the rules affect sell-side institutions. A quarter of those surveyed said the margin rules made OTC derivatives more attractive to sell-side firms, while the remainder were split between believing the rules had no impact or would make them less attractive.

Most respondents are confident that their firms will be at least “somewhat prepared” to meet the collateral rules for the second phase-in of the initial margin requirements on September 1, 2017. A minority of the 55 risk professionals surveyed said they would be fully ready, while a few—all from the buy-side—said they would not be prepared at all.

ISDA’s SIMM: the devil is in the detail

Last September the International Swaps and Derivatives Association (ISDA) launched the Standard Initial Margin Model (SIMM), an industry standard methodology to calculate initial margin for non-cleared derivatives trades. SIMM is a common, transparent and flexible model to calculate regulatory initial margin. It is designed to alleviate the potential disputes caused by an individual firm calculating initial margin requirements based on its own models.

While SIMM implementation is largely straightforward, risk managers caution that the devil is in the details. “It is important that firms have a good infrastructure for SIMM and can bump and reprice to obtain the Greeks required,” says Harry Lipman, Global Head of Bloomberg’s OTC derivatives product. “It’s not rocket science, but firms should take care when laying out the infrastructure for SIMM. You can read the model document in an afternoon, but chasing down the details will be more difficult.”

One risk manager at a major UK bank agreed: “The SIMM model is simple, but inputting to that model takes a long time. There are many factors to consider, such as different tenors, currencies and ways of bumping the curve. Every bank has a different handle on this and it is where everyone will spend a lot of time.”

Collateral optimization in a liquidity constrained environment

As more counterparties come under the initial margin requirements over the next few years, reconciliation problems are likely to emerge. Why? A greater number of exotic and complex trades between banks and their buy-side customers will come into scope. Thus, firms must ensure their infrastructures can support compliance with the new initial margin regulations via SIMM well in advance of becoming in-scope, since setting up the model is time consuming.

The daily posting of initial margin prescribed by regulators will require a great deal of collateral, says McCabe. “Firms always push back on posting collateral because they realize it is a drain on liquidity,” he says. “But they increasingly realize that collateral management—if optimized—can not only save them money, but even make them money.”

Optimizing collateral essentially means determining what collateral is available, eligible and desirable, he adds. In an environment of constrained liquidity, firms must ensure that they do not post collateral that could be more useful or valuable elsewhere.

The creation of a forward looking collateral inventory—which enables firms to determine which collateral is the most appropriate to post—can reduce liquidity risk. “Forward inventory will enable firms to order collateral in a rational way. If a firm understands its forward liquidity position and the collateral it has available, it will be in a very good position to optimize liquidity.