In the aftermath of the financial crisis, regulatory focus on derivatives market collateralization increased.  In fact, the very nature of collateral management has changed significantly. Collateral management and optimization is now a science that is constantly developing, with various strategies like inventory optimization and collateral rebalancing designed to minimize the cost of funding.

Historically, variation margin has been posted bilaterally between counterparties, and the central clearing of OTC derivatives has now resulted in daily and intraday posting of initial margin, as well. 

Market participants are now more risk averse than ever, and variation margin, which was once allowed to be posted on a weekly or even a monthly basis, is now being posted daily to reflect for the MTM changes. Regulators across the globe are now making collateralization mandatory of bilateral derivatives that are too complex to be centrally cleared such as inflation swaps.

For banks and financial services firms, the impacts of Brexit are manifold and one of the most critical amongst them is around collateral management & optimization. Although it is still not clear what proportion of the OTC derivatives market would move to EU, a relocation of business activity from London to various financial centers in Europe would fragment what is presently a single market. This single point, in no uncertain terms, adds further complexity to collateral optimization, as the direct costs arising from market fragmentation, calls for a more mature collateral optimization solution.

Fragmentation and its impacts

Initial margin volume, which needs to be deposited as collateral by clearing members, tends to fall when the portfolios of their clients are large, as this gives opportunities for better risk netting and cross-margining effects at respective central counterparty clearing houses (CCPs). 

A division or relocation of portfolio between CCPs implies higher initial margin, and in an economic sense, even though it isn’t a cost, collateral still needs to be funded. A similar impact can also be seen on the default fund contributions by clearing members where it is expected to be high initially, till the time volumes increase and more participants become members of the clearing houses. As memberships increase, the share of each participant towards the default fund decreases.

This fragmentation and its associated costs may eventually manifest as a larger bid-offer spread, and hence collateral will not only impact back and middle officers, but also trading desks.
Fragmentation of business across multiple CCPs is likely to result in greater costs and greater liquidity demands for market participants, which needs to be offset to some degree by enhanced collateral optimization techniques, such as having a global view of their asset pool and consider collateral costs before making trading decisions.

While non-cash collateral can used to cover requirements, each CCP will have their own list of eligible securities with EU-based ones preferring Euro-denominated collateral. This will require clearing members to keep a constant check on their collateral pools, and ensure continuous calculations are done to meet the requirements in the most efficient way.

Additionally, Brexit may well further affect the value of UK denominated collateral, as seen in the direct aftermath of the Brexit vote. Decreases in the value of UK posted collateral such as sterling cash or gilts, counterparties would be required to post additional margin to cover the exposures.

The key challenges 

Since counterparties and portfolios gets split between regions, the netting effects decrease, and margin requirements increase. When establishing optimization methodologies, firms are likely to face challenges in ensuring collateral is being utilized efficiently and in meeting funding obligations. 

Once collateral obligations are known, firms may find they do not have enough eligible assets to fulfill them. Managers may have to get into additional markets and make investments they wouldn’t typically have. If a CCP accepts EU treasuries and a firm majorly has corporate bonds in its portfolio, then the latter needs to find a market for making this exchange before being able to post.

As firms start getting involved with clearing houses in new European markets, they also need to be able to predict and replicate CCP figures before taking a position.  Margin costs need to be blended into execution price, and trading desks will need to consider this as an additional factor before making business decisions.

Firms need to be able to adapt to multiple regulatory regimes. With ever-evolving regulations, banks should continue to pursue new revenue channels, but constantly review their cost management strategies also. Collateral optimization is one of those strategies that firms must get right to successfully navigate the uncertain regulatory (and Brexit) landscape.

For more information about how we can help UK and EU-based clearing businesses in the run up to Brexit, please get in touch.

RACHAEL ZUKERMAN
Partner (London)
rachael.zukerman@capco.com