Investor demand for exotic and standardised derivatives has shown encouraging signs of recovery since the decline experienced in the immediate aftermath of the global credit crisis. This, coupled with the major regulatory reforms underway in the OTC derivatives market, has prompted firms to review their collateral management processes.

The move to central clearing for the majority of standardised, liquid OTC derivatives instruments has become one of the most fervently debated issues in the post trade space. It is anticipated that a significant percentage of OTC derivatives instruments will become centrally cleared. The remaining OTC derivatives instruments will continue to be bilaterally cleared and will be subject to timely confirmation, robust and resilient auditable processes with frequent reconciliation and effective dispute management, in addition to being subject to appropriate capital requirement levels.

The need to clear some instruments bilaterally and others centrally has raised questions amongst market participants about how to manage collateral in this new environment. Concerns are centred, in part, on the high margin requirements of central clearing, the large capital costs of clearing centrally and bilaterally, and the complexities around providing a consolidated view of counterparty risk across OTC derivatives, exchange traded derivatives and securities lending markets.

In the new derivatives environment, the minimum capital required to become a direct clearing member (DCM) will prove too prohibitive for some participants and prevent them from dealing directly with a central counterparty (CCP). This means that a large number of firms will have to rely on general clearing members (GCM) to novate the trade to the CCP on the firms’ behalf. Clearing trades bilaterally and through a general clearing member (GCM) is expected to increase the capital cost of clearing, given the inability to net positions for margin purposes.

In this complex clearing structure, the need to manage counterparty risk and simplify processes is gaining heightened attention. Critical to the effective management of counterparty risk is ensuring that counterparties have a consistent view of risk exposures through an established collateral and reconciliation process. Sophisticated collateral management enables sell-side participants to understand their exposure across all business units and positions, and allows buy-side participants to calculate their counterparty exposures and to know when they are under/over collateralised on a frequent basis.

Establishing efficient collateral management processes is no small undertaking and requires an initial investment; as a result, some market participants are waiting to see how the introduction of central clearing will evolve in the regulatory reform underway. However, we have, more recently, seen a number of firms taking a more pragmatic approach, and investing in automated collateral services. Indeed, once a firm’s trading volumes start to grow into the hundreds per month – together with the need to meet regulatory requirements – the case for investment in automation is validated by improved risk control and best practices, as well as savings from the efficiencies encountered in manual processing.

Automating the collateral management function offers the opportunity for growth on a variety of fronts i.e. numbers of collateralised counterparties, volumes of open transactions, margin calls and collateral transfers and enhanced reporting and analysis of collateral and margin obligations at any given moment. Ultimately, automation helps firms meet current and impending regulatory requirements, whilst at the same time strengthening and extending trading relationships with counterparties. 

Martin Loxley is the director of collateral management at Omgeo