Collateral management is a vitally important support area. Fund managers who use derivatives need robust processes to calculate and look after the assets deposited as security for the contract. This article looks at some of the supporting activities required and examines how the relationship between the fund manager and its client or fund affects these activities.
OTC Derivatives And Collateral
One of the theoretical attractions of over-the-counter derivatives is the absence of any margining requirements and the associated movements of cash and collateral. This depends, however, on the relative credit standing of the two counterparties--one party might require some form of collateral as a condition of entering into an OTC deal with the lower-rated party.
It's important to realize when discussing credit ratings the fund is the counterparty, not the fund manager. A fund may not be viewed as a particularly good credit risk and so the investment bank counterparty may request collateral--although this may only be required for amounts over a negotiable threshold. The use of collateral in OTC transactions is growing. The International Swaps and Derivatives Association is reporting a steady increase and now estimates that 55% of derivative transactions are secured by collateral.
These margining arrangements are organised through Credit Support Annexes (CSAs) to the ISDA Master Agreements. Each arrangement requires a separate agreement between bank and fund, so the amount of paperwork rises exponentially. There are different legal frameworks available for these CSAs and these need to be carefully selected based on their tax and legal requirements.
The Approach To Operational Risk
Clearing houses in securities and derivative markets manage the risk associated with the transactions between members of the clearing house. Default risk is where a member may not meet their obligation in variation margin calls on futures contracts or may not deliver on the contract.
Default risk is a function of volatility and exposure--it can rise quickly and may need monitoring for a long time. A proactive process, not a reactive response, is the only way to effectively manage the amount of risk. Predicting the level of exposure and likelihood of default is a crucial part of understanding the level of collateral required to mitigate this risk and forms a core part of a clearing house business.
For counterparties to OTC trades there is a similar scenario. Effective risk management is only achieved if the counterparties have the ability to:
* Analyse exposure;
* Measure risk; and
* Manage collateral.
Counterparties need to have a proactive approach to collateral in the same way as an on-exchange clearing house.
Acceptable Collateral Instruments
Collateral must be:
* Immediately realizable, i.e. liquid;
* Not subject to other claim; and
* Deposited with the counterparty's agent (usually a custodian), unless agreed otherwise.
Acceptable collateral would usually include:
* Interest earning cash, in the currencies of the contracts traded or the major currencies;
* Specified forms of bank guarantees, letters of credit and so on;
* Government treasury bonds and bills; and in some cases
* Certain equity securities, supranational bonds and corporate bonds.
Securities used are negotiable between the parties, as are the interest rates applicable to cash balances on the client's accounts at the clearing broker.
The assets are subject to a haircut--that is, they are not counted at 100% of their face value unless they are cash in the appropriate currency. All other asset types will be discounted, reflecting the fact that it may not be possible to realize 100% of their face value at the point at which the default actually happens.
Counterparties are becoming more aware that fund managers will require more flexibility when choosing eligible collateral, as they can only offer assets which are covered within their mandates. Additionally, as fund managers are expected to earn a higher return on their total investments than the standard interest rate used for cash collateral, they may prefer not to tie up large amounts of the portfolio in cash by posting it as collateral.
Specific Risks And Back Office Considerations
By physically transferring the collateral into the name of the clearing member, clearing house or counterparty, the client loses legal ownership of the collateral but retains the beneficial ownership--that is, the rights to any entitlements such as dividends. The client/manager loses the voting rights.
Therefore, a series of risks have now appeared:
* The collateral is now shown as the holder's assetit may be seized in the event of a default by that organisation. Fund managers need to be very careful that a right to segregation is not removed by a rehypothecation clause in the counterparty agreement;
* The fund management company must make sure it has the necessary authority to use segregated fund assets in a non-segregated environment;
* The receiver of the collateral must be certain they have sole claim on the collateral;
* It must be possible to value both the obligation and collateral intra day, if necessary, when markets are volatile;
* Accounting systems must be able to correctly record the collateral, i.e. as on deposit to/from another party;
* The management of the benefits and entitlements including corporate action decisions needs to be fully understood and procedures agreed, including collateral recall and replacement;
* Because the collateral ownership has transferred, the securities or cash may not appear in bank or custodian reconciliations. This can cause severe problems with back office systems, especially in a highly-automated environment where information on positions is passed directly through to trading, reporting and performance software;
* Arrangements need to be made to keep the assets used for collateral separate from those used for stock lending; and
* The fund manager also needs to ensure that procedures are in place to effectively monitor the cost and benefit of the funds using collateral or cash to cover their initial margin requirements.
Segregation Of Collateral And Tax Issues
Any party taking or depositing collateral must ensure that the segregation terms are fully understood and agreed. Regulation affects on what can be done with another party's assets and any right to segregation must be met, while not diluting the value of the collateral.
There may also be tax implications; the transfer of ownership may be construed as a sale of the security resulting in capital gain and benefits such as dividends may appear to be manufactured payments--that is, they arise in the fund account with no supporting documentation showing ownership of the underlying asset.
Pledging Collateral
A solution to some of these problems is to use the collateral pledge.
This process involves a client and the client's custodian signing a pledge form stating that an amount of collateral is held to the order of the counterparty, which will be released to the counterparty on proof of a default by the client being presented (see diagram above). The custodian will ring-fence the collateral if it is a specific asset or maintain a value of assets as a pool against the pledge commitment. The custodian will periodically confirm that the value of the pledge is being held in liquid assets.
As no asset leaves the client, and the custodians are good quality agents as far as the counterparty is concerned, the risk is reduced for everyone. The broker, however, may choose to levy a fee for the administration required to manage this process.
In Summary
The use of collateral does reduce credit risk for the counterparty. It also, however, brings increased legal, tax and operational risk. It is usually much easier, from a management perspective, to use cash instead of securities but this may not be suitable under the terms of the client mandate, or beneficial in terms of fund performance.
This week's Learning Curve was written by David Loader, director of The Derivatives and Securities Consultancy, and Catherine Doherty, principal consultant at Investit, a specialist investment management consultancy.
