A new white paper from the DTCC predicts that margin calls on derivatives could increase by as much as 1,000%. The paper cites regulatory changes that will spur fragmented clearing and a jump in margin calls. With so much that can go wrong, the new clearing regime for derivatives is quickly becoming a major operational headache.
The release of the white paper gave me a chance to speak with Mark Jennis. He is the managing director, strategy and business development, for the DTCC and one of the co-authors of the DTCC paper “Trends, Risks and Opportunities in Collateral Management.”
Derivatives market participants, especially broker-dealers, may have to get used to a significant spike in margin calls, Jennis said.
The root of the problem starts with the regulatory changes of the Dodd-Frank Act and the European Market Infrastructure Regulation legislation, according to the report. Both reform efforts could require initial margin for both counterparties and a reduction or removal of thresholds for variation margin.
“The inclusion of initial margin will significantly increase the amount of collateral required and will create additional margin calls,” according to the report’s authors. These regulatory changes governing the clearing of OTC derivatives will lead to fragmentation in the clearing market and new operational demands, Jennis added.
This will have a ripple effect on ISDA’s standard credit support annex (SCSA) provisions that are part of an ISDA-developed, standard master agreement for bilateral OTC transactions, according to the report. The CSA is the set of rules guiding the posting of collateral by both parties, which must agree to the ISDA contract and CSA conditions.
From the report: “With new clearing requirements for OTC derivatives transactions, CSAs, which have historically covered an entire portfolio of deals with one margin call, now may exclude products offered by different clearinghouses.”
In addition, margin calls in the past have been met in Euros or U.S. dollars “for a host of reasons,” according to the report. The new SCSA encourages better risk mitigation by matching the currency of the collateral with the currency of the underlying trade.
“The challenge to date with this approach is that both the volume and complexity of collateral calls and their settlement will increase as a result,” according to the report. “Under the SCSA, margin calls potentially are in at least the five main G20 currencies (U.S. Dollar, Euro, Japanese Yen, British Pound and Swiss Franc) to start. Depending on the portfolio under the SCSA, margin calls could be in as many as 17 currencies in the future.”
So, we may be seeing the end of one-stop clearing for many firms.
According to the report, the scenario that is emerging is as follows: one firm would use CME and LCH.Clearnet to clear interest rate swaps; ICE Clear and CME to clear credit default swaps; and Eurex and The Options Clearing Corp. to clear equity derivatives.
Ultimately, the use of multiple regional clearing venues per product may have a splintering effect on collateral, the report warned. These multiple routes to clearing may also cause individual daily or even intraday margin calls for each clearinghouse. Of course, there could also be margin calls for OTC bilateral arrangements, Jennis added.
“You put all that together and you could have five to 10 times the number of margin calls you have today,” Jennis said.
Such a surge in margin call volumes and the resulting complexity could overwhelm incumbent operational processes and system infrastructures within banks, buy-side firms and their administrators, according to the report.
“As a result, firms will need to invest in technology and also reengineer the settlement, exceptions management and dispute resolution processes in place today,” according to the DTCC report’s authors. The report also referenced a 2011 Deloitte paper predicting that investments in operations for advanced collateral capabilities could cost $50 million annually for top-tier banks.
Part of that price tag will stem from major impacts on liquidity and risk management, creating “operational nightmare scenarios” that will be “far more extensive than what has been reported thus far,” according to the DTCC report.
For now, new collateral demands and fragmented clearing are causing firms “to build models that are consistent and in agreement with the changes,” Jennis said. Firms will have their work cut out for them as the collateral management aspect is global, multi-faceted and encompasses settlement, financing, reporting and transparency issues. It is also a major cost driver and risk issue.
Are the costs, complexity and ripple effects that come with OTC derivatives reform enough to cause firms to move away from OTC and to exchange-traded instruments?
“I haven’t seen as much of that,” Jennis said. “Maybe you’ll see more as executed and cleared OTC trading continues to move forward. … People are looking to come up with solutions that are flexible and can go across products, geographies and jurisdictions.”
Firms will also have to take on workflow silos that have added to the bottom-line costs and operational risk of derivatives processing. In fact, Jennis said broker-dealers are responding by bringing together both systems and operations and integrating them to undo the silos. In addition, fund managers are beginning to realize that they can no longer afford separate, unintegrated areas that are not synchronized. The same is true for custodians/administrators that are providing outsourced services.
Thus each group is looking at ways to make the collateral management process much more scalable and agile, Jennis said.
In light of these operational burdens, are some firms taking an active approach or a wait and see attitude toward clearing?
“We see both,” Jennis said. “We see some that are way out ahead and building solutions in their own shops. … You see a lot of folks are surveying the different opportunities and being careful about the investments that they make, given all the potential regulatory changes that are out there.”
In particular, the buy side appears to be coming to grips with collateral management and clearing as they review the full cost, risks, challenges and benefits of juggling OTC, bilateral and exchange-traded derivatives, Jennis said. “Firms are looking in a much more integrated way at the decisions they make,” he said. “You will start to see decisions being made that take on many more of these factors than they have in the past.”
One likely outcome from this major reassessment of collateral management and clearing is better coordination between operations and traders.
“Anyone in the front office really needs to be very involved in what’s happening in the middle and back offices because an awful lot of their costs and revenues are a result of that,” Jennis said. “That’s been the enjoyable part of being in this space. We’ve seen a lot more interest enterprise-wide in getting this right.”
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