Buyside: Asset managers ready their systems for OTC clearing

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06 October 2011

Asset managers are assessing the best way to manage the increased collateral obligations for OTC derivatives trades that will be required by new post-trade regulations pending in the US and Europe. However, incomplete regulation is hampering their ability to assess the suitability of systems on offer, finds Dan Barnes.

In the US, under the Dodd-Frank regulation, and in Europe, under the European market infrastructure regulation (Emir), clearing for all standardised OTC derivative contracts is to be carried out via central counterparties by end of 2012 at the latest.

Martin Loxley, commercial director, collateral management, at software provider Omgeo says that the value that CCP clearing provides in the situation of counterparty default was proven when Lehman Brothers collapsed in 2008.

“The process that took place at LCH.Clearnet, in terms of the transfer and the auction of the Lehman's positions, happened in a matter of weeks; however some of the bilateral positions held between Lehman and its counterparties are still in dispute, even today,” he says.

Despite the security it offers, the central clearing model will make life more difficult for the asset management community, warns David Wechter, senior director, collateral management, at system provider Algorithmics.

“The environment the buy-side is exposed to is becoming dramatically more complicated and their core competency is not operations,” he says.”They are going to be classed in the same risk profile as the brokers and banks, held to the same standards and required to have the same operational capacity.”

On top of this the failure of regulators on both sides of the Atlantic to finalise rules in July, as originally planned, is challenging the buy-side’s ability to prepare for centralised clearing.

New regime

Central clearing will enforce standardised processes in post-trade processing, modernising collateral management in the buy-side community.

This may be a jolt for the majority of asset managers; research released by Algorithmics in June indicates that most do not follow best practice in their collateral management; only 46% of respondents said that they made margin calls on a daily basis.

“By margining weekly they can only identify problems weekly, which may potentially increase the time taken to resolve them, whereas if they make calls daily, disputes tend to be smaller and more manageable,” notes Neil Murphy, director, collateral management, at Algorithmics.

Under the new regime, once a trade is passed to a CCP, from an electronic confirmation platform if traded bilaterally, or an exchange, swap execution facility or a multilateral trading facility, the CCP becomes the counterparty.

An initial margin is set by the CCP to cover its counterparty’s credit risk, and variation margin is then set daily according to the changing value of the contract.

"A clearing broker will have to provide a statement everyday or intra-day to their buy-side clients. Accordingly they can pass on charges from the clearing houses and add any additional charges of their own on top of that. From a buy-side perspective this is potentially going to increase their costs,” says Helen Nicol, product manager at collateral management software provider Lombard Risk.

Collateral management systems

Collateral management systems enable a firm to calculate the margin required, identify the collateral needed and automate as much of the notification and calculation process as possible.

But post-Dodd-Frank/Emir they must also tackle a more complicated flow of information than asset managers had previously dealt with. As contracts are now designated standardised or non-standardised, and treated differently on that basis, firms will have to deal with each separately, while maintaining a picture of their overall positions.

“Their IT investment has to build a bridge between the two types of models, non-cleared and centrally cleared." says Jason Orben, global product head of derivatives collateral management, at JPMorgan Worldwide Securities Services.

“If you fail to build that bridge you run the risk of being improperly collateralised. You could miss margin calls, or not take in the appropriate type of margin.”

Under the pending regulations collateral will have to be low risk and highly liquid; for the initial margin will typically be government bonds, and cash for the variation margin.

This presents a challenge for buy-side firms that do not hold the requisite assets under their mandate, as the right collateral will have to be found from elsewhere, using the assets at their disposal. This poses an opportunity for banks and brokers to take ineligible assets as margin from their clients and post eligible margin from their assets to the CCP.

“In reality the majority of funds trading OTCs don't have unlimited amounts of eligible collateral, therefore we have to consider other options such as repos or using the brokers asset transformation solutions,” said one buy-side source.

Long-only investment funds, who typically use derivatives to cover an up-side or a down-side of their position will also find themselves having to post large amounts of collateral for long periods.

“Some of these long-only investment funds could put more initial margin up for their trades than a small investment bank with a balanced portfolio,” says Martin Higgs, senior vice president at custodian bank and collateral management outsourcing provider State Street.

In some cases a collateral management platform may also be required to predict the margin requirement, which may not be made known to the asset manager before the sum is removed from their account.

“CCPs use their own methods of calculating margin requirements, which may be standardised portfolio analysis of risk or value at risk based, but they can be proprietary methods that are not published, such as for ICE Clear Credit, the credit default swap market,” says Ted Allen vice president, collateral management at software provider SunGard, whose ADAPTIV Analytics product is used to duplicate and independently calculate CCP margin valuations.

Making the call

Buy-side firms are faced with a choice says Orben; use an outsourced solution for their collateral management provided by one of the banks, build something internally or develop a hybrid of the two based on licensed software.

“These are big decisions with a significant impact; most costly is to build, least costly is to outsource,” he notes and warns that building in house could incur further costs to upgrade when required.

With no certainty on the rules, a great deal of what an asset manager requires in a collateral management service or system will be flexibility.

Jacqueline Walsh, group derivatives operational officer at buy-side firm F&C, says: “Dodd-Frank will only increase volume and timing pressures for collateral management and, although it is not yet possible to calculate exact figures, it is a given that the ability to have a scalable model will become even more necessary,” says Walsh.

The value of some features is still up in the air; Bramley points out that Lombard Risk’s Colline system provides cross-product margining if required, however it is not clear if the rules will allow it.

Loxley asserts that the preparation firms have made already will not go to waste, although he acknowledges it is made more difficult by the delays.

“OTC derivatives client clearing will happen but I think if there was more clarity around the timelines for implementation of key regulations there would be a quicker uptake of solutions,” he says.

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