Joseph Spiro
The date was April 12, 2011, and U.S. banking regulators published the first draft of proposed rules governing margin requirements applicable to uncleared swaps.
The Dodd-Frank Act, which passed a few years earlier, empowered these regulators with the task of creating and adopting these rules for the U.S. uncleared derivatives industry.
Other global regulators would soon follow, and thus the age of Uncleared Margin Rules (UMR) would begin, setting off more than 11 years of scrambling, innovation, education, and sometimes, pain.
For those of us in the collateral management industry, it was an all-consuming effort, that at times seemed like it would never end. And, while it is true that the effort of getting and staying compliant with UMR will never really end, in September 2022 we reached the point where the all-important Average Aggregated Notional Amount (AANA) threshold stopped lowering each year, which was an important milestone. From that point on, the newly in-scope entities each year have reduced from a flood to a trickle.
So, what’s next?
The collateral management industry has been heads down, focused on re-papering agreements, opening custody accounts, and creating processes to get everyone UMR-compliant for several years. Now that the dust has settled, it’s reasonable to ask where we stand now.
A look around the landscape shows that most firms that needed to get in scope did so. However, the resulting increased volumes and manual processes have left many firms struggling for efficiency. In an environment of higher costs and lower margins, achieving a higher level of efficiency is suddenly more important than ever.
Meanwhile, while the UMR effort was steaming forward, another trend in finance was born: digital assets.
The digital asset industry was born from the Bitcoin whitepaper in 2008, and while Bitcoin is still a central force, the industry has grown well beyond just Bitcoin.
The blockchain, a.k.a. distributed ledger technology (DLT) that Bitcoin introduced can be applied in many areas and has enormous potential to improve processes across the board. This potential is exactly what the collateral industry needs, at a time when it is needed most.
One clear example is the tokenization of real-world assets (RWAs) as collateral.
Treasury bill (T-Bill) tokenization is already actively happening today, albeit at a small scale currently. Several options for tokenized money market funds (MMFs) are also emerging.
The advantage of tokenizing RWAs is that in most cases, these assets are already defined as eligible types of collateral in many collateral agreements, and often they are also eligible forms of collateral, according to UMR regulations.
We aren’t talking about using new types of assets here; we are just discovering a novel way of moving and holding the assets that many are already using.
Gone could be the days of scrambling to get your T- Bills settled before the 3:00 p.m. EST Fed deadline as these assets can now settle on-chain 24/7. This on-chain settlement is transparent, and nearly instantaneous, thereby eliminating the need to chase custodians trying to get settlement confirmation, and wondering which box the asset went to.
Similarly, tokenization of MMF can smooth the ability to transfer ownership of these shares among parties and help ease the reconciliation process, making MMF more fit for widespread use as collateral.
Another emerging trend, while currently still far less mainstream, is the use of cryptocurrencies as collateral.
While this may seem a bridge too far for some (and is currently not approved as a regulatorily accepted form of eligible collateral), accepting cryptocurrency as independent amount (IA) can be a prudent risk management technique.
Take, for example, a Bitcoin total return swap. When a swap dealer is receiving the return on Bitcoin in exchange for the return on some other asset, asking the counterparty to post IA denominated in Bitcoin can reduce risk, as the direction of the collateral is negatively correlated with the direction of the exposure. The operational benefits of using cryptocurrency as collateral are similar to those mentioned about tokenization: near instantaneous, transparent, immutable settlement, available 24/7.
An additional and still-untapped aspect of using digital assets as collateral is the potential use of smart contracts to control the whole process.
Smart contracts can agree on position valuations, agree on collateral amounts, and then settle those amounts, all without the need for human intervention. The operational and cost benefits of using smart contracts in this way are obvious and can’t be overstated.
While many things have changed in the collateral management space over the years, the forms of collateral used and the methods for mobilizing it have remained stagnant for decades.
The use of digital assets has the potential for tremendous benefits in risk reduction and efficiency. These tools offer the promise of a transformative process impact, at a time when we need it most.
(The author Joseph Spiro is a senior product director at Hazeltree where he is focused on helping Hazeltree’s buy-side clients improve their collateral management process, increase efficiency, reduce risk, and increase liquidity. He has been part of the collateral management industry for more than 25 years. Prior to joining Hazeltree, Spiro held the position of U.S. head of collateral at Société Générale, where he was one of the principal members of the dealer community responsible for ushering in UMR phase 1 in 2016, and subsequent phases. Before his time at SG, Spiro held leadership positions at Merrill Lynch, Deutsche Bank, and BNY Mellon. He has contributed to ISDA and other industry working groups on the topic of collateral management and has been a contributor to ISDA publications in the field of collateral management. Spiro holds an undergraduate degree in economics from Rutgers University, and a master’s in business administration from New York University Stern School of Business.)
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