The use of collateral and the implementation of collateral management techniques have changed dramatically with the evolution of financial regulatory reform. As mandatory CCP clearing for sstandardized products have come into effect, bilateral margining for non-cleared swaps remains uncertain. While margin requirements are driven by each CCP’s individual methodology – regulators have proposed even greater and more stringent margin and collateral requirements for non-cleared OTC trades, where both initial and variation margin must be posted. As part of this change, managing margin requirements in careful balance with collateral optimization techniques remain two of the most important issues impacting today’s derivative marketplace.
In part one of this two part blog series, Anna Barbashova, VP in the Numerix Client Solutions Group breaks down today’s collateral challenge, addressing the debate around collateral shortage, sourcing collateral and cost mitigation. In part two we’ll discuss how today’s derivative market participants are meeting these challenges with innovative solutions.
Q:
Significant analysis is required to calculate the CVA of a counterparty position before and after moving trades to a CCP, and calculating the CCP specific initial margin requirements of trades must be considered in the context of the CSA agreement which regulates the collateral of derivatives transactions. Beyond the direct impacts, what are complex interdependencies between various valuations adjustments and funding costs?
A:
As your question states – if central clearing is not taking place, trades are conducted with a counterparty bilaterally and an array of pricing and risk adjustments or “xVAs” have to be incorporated into the valuation. These include CVA, DVA and also FVA. Essentially encompassing your cost of funding, posting collateral to your counterparty does not come free. We should note:
- As a result of regulation trades that are not centrally cleared are subject to higher capital requirements.
- Alternatively, when you move your trades to an exchange or clear OTC derivatives through CCPs you have to post initial margin and variation margin throughout the life of the trade.
- In addition, CCPs are asking for highly liquid collateral such as cash or cash equivalent assets which comes at a higher cost.
Thus, what comes next is central to the complex
interdependencies between valuations adjustments and funding costs. The assessment or estimation institutions have to make regarding whether
to move certain OTC derivatives to CCPs or keep them as bilateral agreements. The goal here is to determine what will cost more – to acquire highly liquid collateral and pay initial and variation margin versus adjusting the price with xVAs, and get hit with higher capital requirements.
In both cases you have to post collateral, and therefore the importance of managing collateral across the institution is a valid and critical action item due to the prediction of various economists who’ve brought to light the debate around
scarcity of collateral.
Collateral management combines various things: sourcing collateral, optimizing postage of collateral to various counterparties and CCPs, optimization of availability of collateral across the institution, identifying cheapest-to-deliver collateral and switching collateral if a CSA agreement allows posting different collateral in different currencies.
Also, renegotiation of existing CSA agreements with counterparties is an important point to mention as it might benefit an institutions in the long run if terms were negotiated advantageously, for example posting assets riskier than cash as collateral, allowing collateral to be posted in various currencies, minimum transfer amounts and reusage of collateral known as rehypothecation. Rules around rehypothecation are not yet final, though if restricted it could lead to a collateral shortage.
Q:
In a recently published academic paper titled “The Economic of Collateral” authored by Ronald W. Anderson and Karin Joeveer of the London School of Economics the notion of collateral scarcity is challenged. Is there a shortage of collateral?
A:
Ronald Anderson and Karin Joeever have done a good job reviewing various research papers on this topic. Results vary depending on the availability of the data, as well as models and approaches. It seems, at least based on their conclusions that there might not be a collateral shortage. However, it depends on a very strong assumption that there is what they call “velocity of collateral.”
This is a very strong assumption. Basically it assumes that collateral can be reinvested and can travel fluidly to one or many institutions freely without any delays and mismatch in settlement dates. Of course, at least from my perspective this is too optimistic and not realistic. This is why the paper discusses various ways in which collateral can be managed in more optimal way.
In short, the authors of the paper mention two major assumptions that might help to relieve the possibility of a collateral shortage on the market. The first assumption is allowing market participants to reuse posted collateral. The second is the desire of market participants to make available the long-term liquid assets they hold to other participants for use in short-term transactions.
Rehypothecation, as mentioned earlier seems like a decent idea but at the same time it can lead to problems where if one institution in the chain defaults all of the others that depend on that collateral might get dragged down as well. The second idea, the desire of market participants to make long-term liquid assets available for the market, depends purely on an institution’s interest in earning yield and the current stability of the market environment.
When trading with a counterparty in the OTC derivative market, CSAs and other collateral agreements allow the counterparty to reuse posted collateral by default, unless the opposite is explicitly stated. The question of reuse of collateral becomes more important when market participants utilize central clearing and the clearing houses can determine how to manage the obtained collateral in the most optimal way.
