Buy-side firms unprepared for OTC derivatives reform.
The study, titled 'Mitigating collateral damage', was conducted during the latter part of 2010 and addressed the challenges that counterparty credit risk and collateral management pose for asset managers in the face of regulatory change.
On 15 December the internal market commissioner of the European Commission (EC), Michel Barnier, unveiled proposals for OTC derivatives trades in Europe to be centrally cleared. Exchange trading is expected to be proposed for the OTC market under MiFID II, the details of which are expected to be outlined by the EC in Q2 2011. In the US, the regulatory bodies for the securities and derivative markets are developing rules for exchange trading, clearing and data collection of OTC derivatives under the powers handed to them by the Dodd-Frank Act, signed into law in July 2010.
For the buy-side, trading via a centrally cleared model adds significant cost. Collateral must be raised that can be posted with the central counterparty as margin to cover potential losses from a defaulting clearing member. This will typically be found through the substitution of those assets held under a client mandate for more secure assets, such as government bonds. In addition, trades are typically made one way for long-only funds, which means that margin requirements cannot be offset, as they can be for banks that have multi-directional trades.
The analysis, based on interviews with 24 buy-side firms, found that over 75% respondents were not able to rehypothecate securities collateral, adding to the strain created by using assets that might otherwise be under management for collateral.
"Over time the amount of collateral needed reduces as exposure reduces," says Patrick Tadie, BNY Mellon's global business head for its Derivatives360. "Firms should be able to take a portion of the collateral posted and use it for other purposes, for example as collateral on another trade."
The survey found little evidence of efforts to systematically optimise collateral, with the portfolio manager typically nominating eligible assets on an ad hoc basis. An optimisation process would ensure that those assets with the lowest value as collateral would be allocated first where eligible, thus saving assets with superior eligibility characteristics for situations where they are needed.
It also found that 38% of respondents were unable to price OTC derivatives internally which limited their ability to manage collateral on a timely basis, creating further inefficiencies in the process.
The consequence for buy-side firms will be an inability to operate efficiently in the OTC space. "[Buy-side firms] will not be using derivatives as much, at least in the short term, until they get their processes and procedures in place," said Tadie. "That adds more uncertainty to their position -- they may not be able to hedge against it as they would like to."
US clearing house, the Depository Trust & Clearing Corporation, OTC trade processing gateway MarkitSERV and technology vendor AcadiaSoft are developing a solution to improve communication related to setting and maintaining the collateral required between counterparties on OTC derivatives trades.
Beginning later in the first quarter of 2011, the MarkitSERV portal will provide clients with integrated access to the AcadiaSoft Messaging Platform, an online service that facilitates and manages communications required for collateral calls. The new service will enable buy- and sell-side counterparties to manage information electronically on exposures, commitments and adjustments to collateral and create an audit trail of all communication about margining.
The solution is the first step taken by the three companies to develop a multi-functional collateral processing platform for the OTC derivative market.