Getting started with Collateral Management

Starting from nothing, how to get your collateral programme up and going

When do I start or Why carry out margining?

Regulations and Margined Markets

Uncleared Margin Regulations for OTC Derivatives

In March 2017 most firms were obliged to begin exchanging Variation Margin as required by regulations around the world. Most firms in the EU, US and Asia are in-scope for the regulations, with some exceptions. If your firm isn't already exchanging VM you should speak to your own legal or compliance teams to find out when or if your firm will ever become in scope for VM.

The regulations apply in stages between 2016 and 2020 with the threshold for inclusion to exchange IM being lowered each 1st of September.  

  • September 2018 : firms with an average notional of €1.5trn or equivalent must begin IM
  • September 2019: The threshold is halved to €0.75trn / €750bn
  • September 2020: The threshold reaches its final level of €8bn

Voluntary Margining for OTC Derivatives

Firms who aren't required to take part in margining by regulation, may still be required by their counterparties to do so. In this case your firm will have negotiated one or more ISDA Credit Support Annexes and are then required to make and receive margin calls each day.

Markets with Margining

Markets other than OTC Derivatives require margining too, these include:

  • Repo Markets
  • Securities Finance / Lending
  • Exchange-Traded Futures and Options
  • TBA Trading
  • FX Margining

Each of these have their own documentation and operational approach to the exchange of margin.

What firms carry out margining?

Clearly, the catalogue of financial firms needing to effectively manage their collateral is vast, but below is a sampling of the types of firms that have a need for such a function within their operations:

  • Asset Managers
  • Hedge Funds
  • Pension Funds
  • Insurers
  • Corporates
  • Buyside Banks
  • Sellside Institutions

Why carry out margining?

The overwhelming drive for the use of collateral is to provide security against the possibility of payment default by the opposing party in atrade. An ISDA 2015 report states, “Credit risk exists whenever a firm has a relationship in which a counterparty has an obligation to make payments or deliveries in the future. There are a number of ways of addressing the credit risk arising from a derivatives transaction, but the use of collateral has long been established as an effective means of mitigation”. It is now customary that firms do not trade with counterparties without collateral agreements.

Prior to the demise of Lehman Brothers in 2008, large banks often required collateral only for smaller or riskier customers (such as hedge funds or niche brokers), under the assumption that other large banks would rarely default on their obligations. The financial world now knows this not to be the case, and with the dramatic increased leverage built into the financial system through derivatives and securitised pools, collaterisation is now mandatory between almost all counterparties.

A series of crises has tested collateral programmes over the years and saved many institutions from major losses. Below is a list of the insolvencies and crises which have tested collateral programmes overthe last 30 years alone.

1990s

  • Bank of Credit and Commerce International (BCCI)
  • Drexel Burnham Lambert• Baring Securities
  • Orange County, California
  • Long-Term Capital Management (LTCM)
  • Russian Sovereign Debt Default (the first one)
  • Asian Financial Crisis

2000s

  • Argentinian Debt Default (the first one)
  • Enron
  • WorldCom
  • Global Financial Crisis

There are also other motivations as to why parties would collateralise their trading activities with their counterparties:

  • Reduction of exposure in order to do more business with each other when credit limits are under pressure.
  • The possibility to achieve regulatory capital savings by transferring or pledging eligible assets.
  • The ability to trade with firms whose credit rating would prohibituncollateralised trading.

More and more firms are collateralising their trades due to the new regulatory landscape in which they now operate. It is not a case of wanting to collateralise their trades; they are now mandated to do so.

These regulatory constraints have elicited a rise in central clearing for OTC derivatives, use of trade repositories, tightening eligibility criteria, Basel III capital charges and a change of internal counterparty credit riskmanagement practices. All types of firms conducting these importanttransactions must now ensure they are meeting their new regulatoryobligations in regard to collateral management.

Business context

What is Collateral Management?

What is Collateral Management?

Collateral management is the process of two parties exchanging assets in order to reduce credit risk associated with any unsecured financial transactions between them. Such counterparties include banks, broker-dealers, insurance companies, hedge funds, pension funds, asset managers and large corporations. The fundamental idea of collateral management is very simple: cash, securities or other instruments such as bonds and equities are passed from one counterparty to another as security for a credit exposure.

Any two parties trading financial instruments that give rise to future cash flows, such as OTC derivatives, run the risk that one of the parties tothe trade may default on a future payment, leaving the non-defaulting party with a financial loss. On any given day, the party required to post collateral to the other is determined by calculating the net present value (NPV) of all future cash flows for each open trade or transaction.

We typically discuss collateral in terms of variation margin (VM) and initial margin (IM). Whilst both are collateral, they serve different purposes.

VM & IM

Variation Margin covers the daily move in value of your portfolio with your counterparty. Initial Margin (sort of a misnomer) is a measure of the overall losses in a portfolio based on simulated scenarios and protects against larger swings in value of the portfolio.

Risk transformation

The purpose of Collateral Management is to transform credit risk into alternative risks which you can manage and control. The resulting risks within your collateral management programme include:

  • Systems risk: you need your collateral systems to work every day
  • Operational risk: your team need to perform their roles every day, and handle the many disputes which will arise, correctly.
  • If you accept securities as collateral
    • Liquidity risk: Should a counterparty default you will want to sell those assets for a good market price. An illiquid market may mean you face difficult in selling the assets for cash
    • Price volatility risk: The market value of securities can move, should they drop significantly your assets won't cover the exposure under the collateral agreement
    • Concentration risk: Like putting all your eggs in one basket, covering your credit risk using a single security would expose you to increased risk.
  • Legal risk: Although the ISDA documentation framework and associated credit support documents are widely used and well tested, your firm will rely both on the ISDA documents, and bankruptcy law in the country of your counterparty to realise assets should they default.

Pre and Post-2008

When collateral management was first introduced in the 1980s, operational and treasury departments within various institutions carried out this risk management function unobtrusively in the background.

This business function was thrown into the limelight with the shatteringfinancial market crash of 2008. The crisis caused treasury and operational departments to be hauled to the front end of businesses,


coming under scrutiny and evaluation like never before. It is no secret that market participants now need to face up to the harsh reality of onerous changes and restrictive, time-consuming regulations, seeing the way in which they operate impacted greatly. For example, firms now need to provide in-depth reports to meet the requirement for transparency set upon them by a number of regulatory constraints, such as the March 1 Variation Margin rules for uncleared OTC derivatives, which prompted the largest repapering exercise of legal documents the industry has ever witnessed.

The financial industry has evolved dramatically in just the last 10 years, and as a result, collateral management can become a seemingly complex process with interrelated functions involving multiple parties.

The multitude of functions include repos, tri-party, collateral outsourcing, collateral arbitrage, collateral tax treatment, cross-border collateralisation, credit risk, counterparty credit limits and enhanced legal protections using ISDA collateral agreements.

How does Collateral Management fit into your business?

Setting up a collateral management programme

Starting from scratch to create a collateral management programme is not a small undertaking. There are many interconnected components from a business and technology point of view.

Business context

Some of the items framing your team include:

  • The executed margin agreements, often in PDF form, which have to be transformed accurately into electronic equivalents
  • Policies and procedures for the team on how to carry out the many responsibilities and handling disputes
  • Reference data on your counterparties such as legal name, unique identifies, settlement accounts
  • Trading data, a source of the official set of open trades or positions with your counterparties
  • Basic contact information for your counterparties, whether via electronic means, phone, email or messaging platform
  • Feedback to the credit risk team on the state of any margin agreement, with exposures and collateral assets held
  • Asset accounts showing what cash and securities you are holding or have delivered to your counterparties
  • Exposure calculations which correctly implement the terms of your margin agreements
  • Workflow tracking for the daily cycle of calls, and for any disputes. Essential to avoid failed calls and ensure staff handle exceptions accurately.
  • Your connection into the selection and funding of assets to deliver outwards
  • Your connection into the settlements teams to receive and deliver assets for each agreement
  • Finally, status reporting either as management reports, dashboards, or other electronic data which tracks and prioritises the state of the many margin agreements being handled

Figure 1 - Collateral management context

 

Which business departments will have contact with your Collateral programme?

Take away this checklist and start appointing a responsible representative for each of those departments or teams.

There isn't a right answer for this, it serves as a checklist for you to consider

  • Legal
  • Credit risk
  • Trading / Front Office
  • Treasury
  • Counterparty Management / KYC / Static Data
  • Cash settlement
  • Bond settlement
  • COO / CEO

Systems Context

How does Collateral fit into your systems landscape?

Systems context

In a typical firm there will be many systems directly or indirectly connecting to support a collateral management platform and team.

  • The ultimate source of information is Trading systems which usually feed a secondary ‘books and records’ system which holds the official positions at the end of each business day
  • Related to trading are the Risk and Pricing systems which provide the underlying calculations to support pricing of trades and their subsequent valuations
  • Your legal systems may supply your official record of how counterparty entities exist and are related to their group companies and funds
  • The credit risk systems will track credit line utilisation taking into account the output from collateral management
  • Calculating Variation Margin and Initial Margin need quite different pieces of software. Both must take account of the terms of your margin agreements which may contain specific provisions on how VM & IM are to be derived.
  • A clearing house will provide the official VM & IM figures for cleared business
  • Your team will need to instruct settlement of cash and securities, preferably through an integrated approach with your operations teams
  • Your treasury may well be the ultimate owner of the assets you give and receive, and also have a strong input to selecting and optimising assets for the benefit of your firm.
  • Should a dispute occur on a call, you will need to track the dispute according to terms in your CSA, or in the regulations, to ensure you meet the timing requirements and remain compliant.
  • Should a counterparty default (go bust) you will need procedures and mechanisms to secure any assets and block further outflows where possible
  • And finally a large part of collateral management is hoping that your own books and records of positions agree with your counterparties. There are many ways to achieve this, using desktop tools, web platforms and market infrastructure

Which systems will make contact with your CM programme?

There is no right answer for this, use it as a checklist.

  • Trading
  • Legal
  • Credit risk
  • Books and records / trade warehouse
  • Valuations
  • Margin calculator
  • Clearing house(s)
  • Cash settlement
  • Bond settlement
  • Treasury
  • Asset optimiser
  • Dispute tracking
  • Workflow
  • Default management
  • Portfolio reconciliation
  • Margin messaging
  • Email

Where do I start?

Where to start?

Starting somewhere

The priorities to begin managing collateral tend to cover these top items:

  1. Appointing a team to make it all happen
  2. Building a project plan
  3. Finding the margin agreements that exist now or will exist soon
  4. Choosing a system or platform on which to run the programme
  5. Appointing a stakeholders group to guide the creation project
  6. Agreeing milestones to measure progress by

Platform Choice

The systems or platform choice can include:

  1. Appointing an external service provider to make this happen
  2. Buying a software package with an integration project for on-premise systems
  3. Using CloudMargin

Your team

At a minimum someone needs to be the "Head of" Collateral Management, in a typical firm the team may consist of:

  • The Team Leader / Head of
  • A deputy team leader
  • A number of team members who carry out day to day margin calls and operational tasks

Your team's responsibilities

The team needs to cover many tasks including:

  1. Setting policies for the negotiation of collateral agreements
  2. Loading those agreements into your chosen operational platform and testing they perform as written
  3. Checking the state of the systems each morning to be sure they received feeds of trades and their valuations, asset receipts and has carried out the exposure calculations for todays calls and receipts
  4. Carrying out the daily calls, or receiving incoming calls
  5. Recording the calls and receipts and their outcomes
  6. Recording any disputes or failed calls
  7. Recording agreed asset movements
  8. Monitoring that asset movements take place as booked (there will be a time delay between booking a movement and assets arriving)
  9. Carrying out portfolio reconciliations
  10. Resolving disputes
  11. Handling any asset substitution requests
  12. Reporting on the state of agreements, including the exposure covered, physically received assets, the net risks, disputes and operational performance

Your systems

Later we will discuss systems in more details, but for now the tasks your systems will need to carry out include:

  • Receiving an overnight trade feed, with updated valuations, for each counterparty with a collateral agreements
  • Applying the rules and provisions of each margin agreement to arrive at todays calls or receipts
  • Tracking the daily operational workflows mentioned above
  • Recording the collateral assets and their valuations
  • Recording disputes and the associated workflow
  • Providing reports
  • Running risk reports on the collateral assets and agreements (or having an interface to a system that can)

Your launch plan

The top level items in your plan to get started need to include:

  • Appointing a team, or at least one person responsible for owning Collateral Management as their 'day job'
  • Appointing stakeholders from around the business which may come from Operations, Credit Risk, Legal, Technology and the Middle Office.
  • Finding a platform to run your programme on and having it available within your firm
  • Integrating your platform with your other internal systems such as 'trade warehouse', credit risk, legal and settlements
  • Creating operational procedures governing how the team should work on a daily basis, and when to escalate exceptions
  • Training the team
  • Loading agreements into the system
  • Testing the systems
  • Making contact with counterparties to begin making calls
  • Creating management reports on the state of the programme

What platform will you run your CM programme on?

Use this as a checklist

  • Excel? (not recommended)
  • CloudMargin (please contact us)
  • Software developed in-house
  • Software bought from a third party
  • Something else

Terminology

Common terms

Common terminology

The terms and acronyms used within the collateral management world are vast, and can often confuse the most experienced collateral ‘guru’. Listed below are the most essential terms that will allow you to better understand collateral management, and the processes it involves.

Credit Support Annex (CSA)A legal agreement which sets forth the terms and conditions of the credit arrangements between the counterparties. Is usually based on either UK or US law, and sometimes Japanese law.

Over-the-Counter (OTC)The over-the-counter derivatives marketrefers to a marketplace that is conducted outside a central exchange. These derivatives are privately negotiated between two parties, compared to listed derivatives which are traded through an established exchange or other intermediary. (Listed derivatives would include futures and options.)

Base Currency: The currency set out within the CSA that will be used in all collateral transactions between the counterparties, unless otherwise stated. The exposure for the agreement will be expressed in this base currency by converting all the transactions to this single currency and netted together.

Dispute: At the point of a margin call. disputes may arise where one party doesn't agree with the amount being called by the other. They must then each follow a procedure to try and resolve the dispute.

Initial Margin (IM): The sum of money that could conceivably be lost over a defined period, post a default. The period is defined by regulation and differs by instrument from 1 day to 20 days or more. See also Independent Amount.

Variation Margin (VM): The change in the mark-to-market value (unrealized profit/loss) of a portfolio in a one day period.  

Margin CallA request made by the party with a net positive gain to their counterparty to post additional collateral to offset credit risk prior to the expiration of the terms of the contract. A call from one party will be seen as a 'received call' by the other. 

Mark to Market (MTM)Currency valuation of a trade, security or portfolio based on available comparative trade prices in the open market within a stated time frame. MTM does not take into account any price slippage or liquidity effect that might occur from exiting the deal inthe open market, but uses the same or similar transaction prices asindicators of value.

Independent Amount: An additional amount, which is paid above the mark-to-market value of the trade or portfolio. The Independent Amount is required to offset the potential future exposure or credit risk between margin call calculation periods. Within a collateral agreement the Independant Amount can quite often also be the Initial Margin, which is recalculated every day.

Threshold AmountThe amount of unsecured credit risk that two counterparties are willing to accept before a collateral demand will be made. The counterparties typically agree to a Threshold Amount prior to dealing, and it will be set out within the CSA.

Minimum Transfer Amount (MTA): The smallest amount of currency value that is allowable for transfer as collateral.

Haircut: A percentage applied to the mark-to-market value of collateral securities, which reduces its value for collateralisation purposes. The haircut, also known as the Valuation Percentage, protects the collateral taker from drops in the collateral’s value between margin call periods.