Today’s crucial role of a collateral management strategy

Today’s crucial role of a collateral management strategy

Collateral management solutions have evolved over the past decades, from spreadsheet calculations to cloud-based solutions. The most important driver for this evolution is the continuous change and the complexity of the requirements in this space. Not only have the solutions for collateral management evolved, the scope of companies that need to manage their collateral has widened too. Today, the COVID-19 related market stress has highlighted how crucial it is to adopt a collateral management strategy.

In the meantime, the implementation of the Uncleared Margin Rules (UMR) are covering increasingly more entities with each phase. UMR is mainly affecting financial entities yet some non-financial entities are also considered to be in scope. Corporate treasurers are in the process of clarifying if they are in certain categories and if they are in the ‘covered entities’, which will be elaborated in this article.

Why is it more important today?

With the COVID-19 pandemic sweeping the world, financial markets have seen movements beyond expectations, proving once again the importance of having structured collateral management in place. Even in low-volatile financial environments, lack of automation in collateral management has put companies in difficult situations, particularly the buy side. Collateral movements and margin calls relying on manual processes, emails, faxes or spreadsheets show the insufficiency of management, raising concerns on transparency and operational risk.

Central banks are swiftly responding to the changes that have impacted the economy during COVID-19, in order to increase liquidity and ease the collateralization processes. The ECB, like other major central banks, has already taken action such as easing the conditions for Targeted Longer-term refinancing operations (TLTRO III) and recalibrating to further support the real economy. It has also announced collateral easing measures and broadened the eligible assets to mitigate the tightening of financial conditions. The ECB is also taking steps to mitigate the impact of rating downgrades on collateral availability.

The ‘unexpected’ side of COVID-19 is proving the importance of collateral management systems with straight-through-process (STP) that provide automation processes of collateralization and payments as well as generating statements. Systems with flexible configurations and swift support are a priority, as the new rules and decisions from the regulators need to be executed in a timely manner. The security of these systems is also key due to the remote working conditions.

Moreover, the shift to cloud-based technology on the sell-side is being followed by the buy-side of the collateral ecosystem; enhancing mobility and productivity, improving efficiency in resources (front to back) while managing complexity, and providing cost reduction as software or hardware implementation is not required.

Depending on your organization’s current system in place, you may either pick and select modular parts of a platform you are already using or consider an end-to-end cloud solution.

What are uncleared margin rules?

With the final framework on margin requirements for non-centrally cleared derivatives, BCBS-IOSCO, established a set of standards for OTC derivatives markets. Regulators adapted this framework and set rules referred to as uncleared margin rules (UMRs).

This framework and requirements are being implemented in multiple jurisdictions with a phase in approach. The entities in-scope who enter certain OTC derivative transactions on a non-centrally cleared basis are required to exchange initial and variation margin as appropriate to the counterparty risks posed by these transactions.

The implementation of the variation margin (VM), compliant with UMR, occurred in early 2017. Initial margin (IM) requirements continue to phase-in annually. The margin requirements for non-centrally cleared derivatives framework guidelines were introduced for two main reasons:

  • Minimize systemic risk within the non-centrally cleared derivatives. This minimizing is aimed to limit the contagion effect.
  • Promote central clearing. While central clearing solutions impose additional costs, they support a reduction systemic risk.

While the first four phases have been implemented according to the relevant aggregate average notional amount (AANA) thresholds, it is now time for phases 5 and 6; each of which were delayed by a year to allow more time for the firms in scope to be prepared.

Phase 5: In-scope firms with more than €50 billion in AANA of non-centrally cleared derivatives will need to ensure compliance by 1 September 2021 (before COVID-19, the timeline was 1 September, 2020).

Phase 6: In-scope firms with more than €8 billion in AANA of non-centrally cleared derivatives will need to ensure compliance by 1 September 2022 (before COVID-19, the timeline was 1 September, 2021).

These rules have a direct impact on a wide range of financial counterparties (FCs) as well as non-financial counterparties (NFCs) that trade derivatives for purposes other than hedging. NFCs are less interconnected than FCs, as they are predominantly active in one class of OTC derivatives only. Therefore, they do not pose high systemic risk to the financial system compared to FCs. NFCs are also further divided based on their volumes of derivative trading activities for reasons apart from hedging. However, NFCs exceeding the asset class specific EMIR clearing thresholds are considered as NFC+; which are in scope where the margin rules apply. Those NFCs that are under these clearing thresholds with the purpose mainly for hedging their commercial activities are considered as NFC- and out of scope.

Process change

The IM rules are a ‘game-changer’ for the uncleared market, forcing extensive front-to-back changes onto in-scope parties. Significant IT and operational reforms are required across the industry to meet the IM rules. But there is also a movement to selecting the right custodian.

Analyzing and developing the process chains can reduce workloads while minimizing operational risk, which can lead to cost savings. Due to the complexity and workloads on resources; managing of collateral can no longer be supported by spreadsheets and is being replaced by dedicated systems in which connectivity and flexibility are key success factors.

How to be prepared

Review and design your roadmap

Define your category for the UMR. Are you an NFC+? Is your entity ready to comply with the new rules? Have you disclosed with your counterparties if you are an NFC+?

Every participant should adopt a strategic approach for the collateral ecosystem to function properly. Companies should map how to deal with the implication of the financial risks, regulatory obligations, and operational workload.

Determine your target operating model to ensure your company is future proof. More specifically, determine your collateral management function as is and for the future.

Review your CSA documentation and third-party custodian operations for implementing the UMR.

Empower your company with the right technology

Does your technology support the calculation and monitoring of the margin requirements?

Companies can either in-source or out-source their management of collateral. Building in-house solutions requires extensive cooperation between front-to-back offices and IT systems to capture the complexity of the needs from pre-trade to post-trade processing. Given this, only the largest firms are likely to fully in-source these functions, leaving most firms to out-source some elements of their collateral management program.

Optimal utilization of resources

Collateral management requires a team with in-depth experience and knowledge to support a well-defined reporting system and processes in place. From front-to-back offices, credit analysis to valuations, the process optimization and implementation will increase the utilization of resources.

Conduct a scan to identify and analyze the current structure. Take it one step further with workshops and interviews to thoroughly study relevant documents such as procedures, processes and reports.