Collateralization and Margin Management: How Efficient is Efficient

There was a time you could borrow money from your parents to buy a fancy new gadget knowing very well you were never going to pay it back. In fact, your parents knew it too. But they trusted you none the less and quietly agreed.

It was a very similar environment prior to the credit crisis. Sure, we’ll trust you. You are a big name, we want you as a customer and you do not have to post much—or any—collateral for us to do business. You are too big of a name to default anyway.

How the world has changed. The Lehman Brothers’ default made sure of that. Collateral management has now moved up to the forefront of OTC trading and settlement. Going forward regulators are laying down a new set of rules that will significantly change the way collateral and margin management is being done.

It is not only the regulators but also major market participants that are acting to prevent a reoccurrence of the 2008 crisis. The Dodd Frank Act, along with the introduction of Swap Execution Facilities (SEF) and central counterparty (CCP) clearing of a broad set of OTC derivatives may initially increase margin and collateral requirements for most, but the combined effect will be less systemic risk and a more stable market structure. Even non-cleared OTC Swaps will require collateral and margin at levels as yet to be defined by the regulators. It will in short dramatically change the way OTC business is conducted.

OTC Markets and the treatment of collateral will change dramatically in the new environment. Banks and broker dealers are facing pressure on profit margins and the higher costs associated with increased capital charges will have to be replaced by increased efficiencies or passed on directly to their customers.

Collateral management is historically a fragmented and silo based afterthought of the business of OTC trading. While often underfunded and ignored, the new regulatory ecosystem is changing current practices in OTC collateral processes. What has become exceedingly clear is that current practices will no longer be acceptable.

The greatest efficiencies will be found through the introduction of solutions and services that combine straight through processing with the collateral process. From portfolio reconciliation all the way through settlement, there is a large amount of automation that can be introduced. The market is naturally moving in that direction as the efficiencies it promises are just too big to ignore.

On the buy side, whether it is a hedge fund or a traditional fund manager, the need to efficiently manage margin and liquidity is not only a necessity but in some cases a matter of survival. This makes adopting sophisticated tools and platforms to efficiently manage the collateral process an absolute key requirement in today’s hyper-competitive environment.

Investment strategies have become more complex, resulting in more diverse assets and instruments being held in portfolios. It is no longer enough to simply manage market and credit risk across a portfolio of assets consisting of both simple and increasingly sophisticated derivatives. If a major investor has the legal right to redeem his investment at a given point in time, the cash needs to be available to be turned over within the contractually agreed redemption window. Given renewed pressure from external investors for redemption risk and volatile market conditions, optimal management of cash and collateral has become the key.

The TABB Group Vision Note Collateralization and Margin Management: How Efficient is Efficient? This report examines the current state of affairs in the collateral process and margin management for OTC instruments, including the challenges and opportunities facing the industry. It also examines how the changing regulatory landscape and ecosystem will shift business models for market participants, and examines the opportunities and threats to existing business models.