Author: Olivier Grimonpont is Global Head of Securities Financing and Collateral Management Products, Euroclear
When G20 leaders at their 2009 Pittsburgh summit demanded central clearing, electronic trading and reporting of liquid swaps, they also recognised that a sizeable minority of useful OTC instruments were too customised and idiosyncratic to fit into the mainstream. But they were adamant that their overriding objective — reducing systemic risk — called for structural reform of these bilateral swaps too. Thus, as legislators and regulators in major jurisdictions faced up to the challenge of transposing G20-mandated rules for liquid, centrally-cleared swaps into existing legal frameworks, the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) set about establishing new global principles to guide local regulation of bilateral OTC swaps.
From September 2016, bilateral swaps trading will become safer, from a counterparty risk perspective, but at a cost. In Europe, as with the central clearing and reporting mandates, new margin requirements for bilaterally cleared OTC derivatives are enacted under the European Market Infrastructure Directive (EMIR). Informed by BCBS-IOSCO principles, EMIR requires exchange of initial and variation margin on a gross basis, calculation of margin based on consistent methodologies, and new collateral segregation arrangements that allow for immediate availability of margin so that both parties to the transaction are adequately protected in the event of default.
Another parallel with central clearing rules is the phased-in timetable for the introduction of margin requirements for bilateral OTC derivatives, which puts the largest and most-frequent users, i.e. major banks and dealers, first in line to meet the regulatory deadline, followed 12 months later by other high volume counterparties. While the core principles have been known for some time — the deadline for the start of the new regime has been postponed once — the complexity of the new rules and the departure they represent from established practice add up to a major operational challenge for financial institutions already struggling with multiple rule changes and compliance check-lists.
In fact, the new rules could prompt a radical rethink of collateral management by banks’ OTC derivatives desks. Historically, the bilateral nature of the OTC swaps market has led, understandably, to a variety of margin arrangements between counterparties, facilitated by the flexibility of the credit support annex (CSA) that governs margin exchange, and driven by relationships rather than regulations.
Government bonds have often been used as collateral for initial margin (IM), but banks — which typically dictate terms in the bilateral OTC market — have often preferred the convenience, certainty and liquidity of cash. But while CSAs will still allow for a variety of collateral types and arrangements to be utilised, the new BCBS-IOSCO rules are likely to bring about a certain amount of standardisation, increasing the use of securities as collateral at the expense of cash.
A critical reason for this shift is that banks are penalised for holding counterparties’ cash on their balance sheets under Basel III’s liquidity coverage ratio. And, in addition to having the disadvantage of being fungible and therefore extremely difficult to segregate, cash is less suited to a regulatory environment in which collateral for IM must be exchanged, held and monitored in a manner that is transparently safe and secure from the perspective both of the collateral pledger and pledgee.
In comparison to cash, securities do not travel as well, facing numerous barriers and sources of friction that slow their circulation around the financial markets. Certainly, OTC derivatives desks may struggle at first to adapt to greater use or acceptance of securities for initial margin. This will change over time, not just because of the merits of securities as an easily segregated and traceable form of collateral under the new BCBS-IOSCO regime, but also due of a number of developments and innovations.
First, the combined impact of macro-economic trends and market reforms on the demand and supply of collateral is forcing banks to adopt a more co-ordinated, enterprise-wide approach to collateral management, with expertise and information being shared systematically across desks. This is providing higher levels of visibility of available assets, but it is also encouraging the cross-fertilisation of ideas, with repo desks supporting the needs of colleagues to utilise the repo markets more effectively for collateral upgrade or transformation purposes.
Second, market infrastructure reforms and initiatives are making it easier to move securities between accounts and across borders, notably in Europe. The combination of the Central Securities Depository Regulation and TARGET2-Securities is taking down many of the national barriers to pan-European collateral optimisation, while banks will be able to further streamline the collateral required to settle securities through changes to the Eurosystem’s correspondent central banking model.
Third, market infrastructure operators are responding to the regulatory reform process, both by developing new services and by collaborating more widely with each other and with clients to support greater transparency and mobility of assets used for collateral purposes.
Securities may never flow as freely as cash through the arteries of the financial markets. But reforms such as those tightening up the margin requirements for bilateral OTC derivatives demand innovation as well as compliance from banks and their counterparties. Derivatives market participants are already re-examining their process to optimise use of available collateral resources, but new regulatory frameworks sometimes also bring about new roles and responsibilities.
For example, the requirement to segregate and hold margin for bilateral OTC derivatives transactions so that it is immediately accessible to pledgor and pledgee in the event of default is not easily addressed through existing mechanisms and relationships. In a forthcoming article, we will look at the operational challenges of ensuring the necessary levels of protection, access and visibility required by the BCBS-IOSCO framework, on both a bilateral and tri-party basis.