Collateral is fast becoming an increasingly important feature of the new market and regulatory landscape and perhaps nowhere does this represent more dramatic change than in the OTC derivatives market. Dodd-Frank and the European Market Infrastructure (EMIR) regulations have been introduced in part to assure the market can safely absorb a major bank failure. The regulations accomplish this by assuring all exposures are sufficiently collateralized through the combination of central clearing and the introduction of new un-cleared margin rules.
Yet, despite the increased role of collateral as the primary risk mitigator for OTC markets, the processes employed in the exchange of collateral are inefficient, error prone and leave an unacceptable amount of risk in the market. In today’s collateral world the margining process is siloed and manual. Each party to a margin relationship uses their own pricing, reference data and models to calculate the margin due to or from their counterparty. Calls are often exchanged only periodically using manual methods highly dependent on people, email and spreadsheets. Virtually all calculations and calls differ between parties and the result is ongoing disputes and increased market risk.
These issues and risks that have been painfully accepted in the unregulated market will no longer be tolerated post-regulation. Under the new rules all agreements must be collateralized and margin must be exchanged and settled daily. The exchange of gross initial margin (IM) between trading counterparties will be mandatory. Margin disputes which are not promptly resolved will be subject to additional margin requirements. For major industry participants, these regulations take effect on Sept. 1, 2016. While the IM component will be phased in over the course of several years, the requirement to post variation margin (VM) daily has no phase-in period, forcing many participants to post VM where it was not previously required.
These rules will dramatically increase the work required to manage collateral exchanges. New or amended agreements will need to be established for hundreds of thousands of agreements. Added diligence will be required to assure consistent margin calculations and prompt dispute resolution. Audit trails will need to be created in preparation for regulatory oversight. In addition, when fully implemented, the regulations will result in a substantial increase in margin calls and associated collateral movements--to 3 to 10 times current levels. The operational challenges posed by these regulatory changes cannot be met with the fragmented mix of siloed, manual processes currently in place.
The AcadiaSoft Collateral Hub, which 28 major global banks began testing last month, is the result of a major industry initiative focused not only on satisfying the new rules but also on the redesign and automation of the margin process. The Hub introduces an exceptions based process where intervention is limited to the infrequent disputes, which immediately isolated and resolved in a timely, high priority manner.
The Hub achieves this break-though by embedding standard calculations, workflows and shared data in the process. To assure consistent calculations, collateral terms are pre-agreed between parties and used in a standard margin calculation that is based upon the ISDA SIMM model. Comparisons of inputs including sensitivities are available to allow clients to identify and minimize disputes at the input level--before issuing margin calls. Automation of collateral workflow makes the process as simple and efficient as possible, allowing a focus on exceptions. Dispute management capabilities permit tracking and resolution of differences prior to penalties kicking in. Finally, a shared central audit trail is maintained, increasing transparency and control.
The new margin rules for non-cleared derivatives are fast approaching. Will you be ready?