Sep 9, 2014

Part II: How to Manage Collateral and Funding Risk in the Most Optimal Way – An Expert View with Anna Barbashova

With U.S. regulators proposing new margin rules for uncleared swaps, Wall Street is once again reeling over what could cause a slew of operational and legal challenges for financial firms operating within the OTC derivatives market. Word on the Street has it that margin requirements for uncleared swaps could become 40 to 45 percent higher than cleared transactions1. This in turn, has us once again thinking about the importance of collateral optimization, and perhaps more importantly the most effective ways to manage the risk associated with it.

In Part I of our blog series, Considering Collateral,  Anna Barbashova, Numerix Vice Presidenthighlighted the collateral challenges that market participants are facing today.  She explored the debate around collateral shortage, sourcing collateral and cost mitigation. In Part II of our discussion, we’ll have a closer look at how derivative market participants are meeting some of these challenges with innovative solutions to optimize collateral processes and reduce funding risk.

Q:

How can an institution go about reducing the cost of collateral and ultimately manage the risk associated with funding collateral?

A:

From the individual institution point-of-view, especially given recent news, collateral management is now one of the highest priorities that every company is looking at. There are two major problems that every firm has to solve: one, how to effectively manage and optimize usage of collateral across various silos; and two, how to make a decision about whether to switch OTC derivatives trading from bilateral relationships to centrally cleared activities through CCPs.

Overall, to effectively navigate collateral management processes, today’s financial institutions need to consider the following three areas:

1. Developing a collateral system that can be integrated across various silos, which leverages collateral availability across all company departments.

Below is a checklist of points to consider for the development of an optimized collateral system:

 

 

 

 

 

 

 

 

2. Renegotiating CSAs

Many institutions are now considering renegotiating their CSA agreements with their counterparties. On one hand, many want to renegotiate and simplify CSAs to allow only one type of collateral to be posted. This would eliminate complications in instrument valuations, as well as help with the identification of cheapest-to-deliver collateral. On the other hand, others want to actually include risky assets with haircuts as one of the possible collaterals. This would enable them to post other collaterals-in case of scarcity of cash or sovereign bonds, for example.

3. Moving to CCPs

Many of today’s financial institutions need to make the decision between staying with bilateral CSAs and being subject to higher capital requirements versus moving trades to be cleared through CCPs and estimating the cost of initial, and subsequent variation margins.

Overall, it has become increasingly important to re-examine trade profitability from a holistic perspective when making decisions, especially in light of all of the costs now associated with derivatives trading, ranging from the XVAs—such as Credit Valuation Adjustment (CVA), Funding Valuation Adjustment (FVA), Debit Valuation Adjustment (DVA) and Capital Valuation Adjustment (KVA)—to capital requirements and initial/subsequent variation margins.  Looking at the changing landscape of the post-crisis derivative markets, we can’t help but notice that profit margins have been notably shrinking for many market participants as they navigate this brave new world.

When considering a move to CCPs, practitioners should keep in mind their bottom line trade profitability and the tradeoff between counterparty risk and funding risk/costs. As the market moves towards higher collateralization to address counterparty risk, banks need to make trading and risk decisions by fully incorporating funding costs and risks into the equation.

Q:

How are vendors helping institutions to meet these challenges?

A:

Vendors can help to set-up collateral management systems, including assistance with decision-making in terms of leveraging CCPs versus bilateral agreements with their counterparties, and what would be best for an individual financial institution from a profitability standpoint. 

For example, one major European bank we spoke with was not sure if it was better to switch to a central clearing counterparty and post initial margin—or to stay with their counterparties’ bilateral agreements.  With the help of an outside vendor to assist with decision-making and initial margin calculations, they eventually chose to post initial margin and move to the CCP.

If looking to select an external vendor system, we recommend a checklist of parameters and “must-have” capabilities per below:

 

 

 

 

 

 

1Financial Technologies Forum, ftfnews.com, “Uncleared Swaps Hit with Steep Margin Increases,” September 5, 2014

Blog Post - Sep 22, 2011

“Real-time” Trading and Risk Demands Drive Cloud Innovation for Complex Derivatives

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