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Collateral Management Gets Complicated: The Mixed Clearing Challenge

With input from key market participants, Omgeo’s Martin Loxley gives a comprehensive view of managing collateral for bilateral and centrally cleared derivatives.

The more extensive use of central clearing for OTC derivatives will require financial institutions to manage collateral in a mixed bilateral and CCP environment, which is potentially both a cost burden and a processing challenge. With input from key market participants, Omgeo’s Martin Loxley gives a comprehensive view of managing collateral for bilateral and centrally cleared derivatives.

The Challenge

Central clearing is a game changer for the Over-the-Counter (OTC) derivatives industry. The use of central counterparty clearing (CCP) presents cost and operational challenges to firms which will have to manage collateral in both bilateral and central clearing environments.

“One of the challenging aspects of the CCP model is that because it does not completely take over the bilateral model, the industry actually ends up with a more complicated framework that creates a potential increase in operational overhead and extra complexity in processing,” said Nick Newport, Director at InteDelta.

The cost of central clearing for OTC derivatives is considerable and a pressing concern for most financial institutions. Specifically, many smaller financial institutions may struggle to fund collateral requirements, both in terms of the amounts and high quality of assets likely to be required by Clearing Houses as margin. Also, the minimum capital required to become a direct clearing member (DCM) will prevent some financial institutions from directly clearing with a CCP so many firms will need to rely upon general clearing members (GCMs) to support their central clearing needs. Therefore, establishing the strategy, structure and process for connectivity to Clearing Houses is the first step in assessing how a firm can best design its mixed collateral management strategy.

There are various factors to be considered when reviewing GCMs. “The first consideration will be what proportion of the business will end up going through a Clearing House and what volume will remain traded on a bilateral basis, including the non-commoditized derivatives such as structured products,” said Newport.

Currently regulators are looking to put standardized trades, such as certain Interest rate swaps (IRS), credit default swaps (CDS) and equity options through Clearing Houses which means that for many firms a significant majority of OTC derivatives volume will be centrally cleared. Alternatively, many firms could look to gain processing efficiencies through channeling both bilateral and CCP volumes through a general clearing member who can support these dual processes, said Newport.

The Future

Post-financial crisis, financial institutions and especially buy-side firms are more focused on managing counterparty risk and will require information on collateral activities across different product lines including OTC, centrally cleared derivatives and securities lending, said Newport.

“[Firms] will want to obtain an increasingly greater amount of information on exposures to various counterparties from their general clearing member(s) and they will want to receive that information on exposures in as timely manner and granular fashion as possible,” said Newport. There will be pressure on the service providers to deliver high quality, transparent and timely information to their clients in a user-friendly format such as online reporting, he added.

Electronic messaging for margin calls may be a key element of the overall messaging and information architecture required to support such a consolidated view of collateral activity. There are various solutions available in the market that automate margin call communication, however, firms may use different solutions and will therefore need to use various methods of communication.

Messaging and collateral vendor solutions are developing to support new central clearing requirements, however, the degree to which buy side firms are proactively developing new collateral management strategies today is mixed.

Despite efforts by all parties to identify the most efficient collateral management strategy for a mixed clearing environment, many are waiting to see how the introduction of central clearing for standardized OTC derivatives will evolve with regulatory reform currently underway in both the US and in Europe.

Some firms will wait and see but others are being more proactive and are already looking to clear directly or indirectly in the markets where central clearing already exists, such as for interest-rate swaps, single name or Index CDS and equity options. There is still a lot of dialogue that needs to take place on the pragmatic approach to central clearing included in certain aspects of proposed regulation.

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