Collateral choices

Outsourcing collateral management in OTC derivatives

With the ability to provide substantial flexibility at relatively low cost, it is no surprise that derivatives continue to grow in popularity. Derivatives enable participants to obtain exposure to a counterparty’s profit or loss on a given investment, with OTC derivatives enabling participants to trade bilaterally with a counterparty of their choice. Commonly backed by securities or cash collateral to guard against counterparty default, OTC derivatives transactions today underlay a wide range of hedging and alternative investment strategies.

Following the 2008 market downturn, derivatives market participants, regulators, legislators and other stakeholders have been moving towards a number of trends, including: standardisation and simplification of OTC derivatives contracts; greater market transparency through the establishment of trade repositories; migration of OTC derivatives business to central counterparties (CCPs); and requiring market participants to engage in risk mitigation processes. Today’s OTC derivatives markets demand stronger reporting, more intensive processing, more accurate pricing and much more effective management of collateral.

The wheres and the whys

A 2010 BNY Mellon survey of Canadian, European and US pensions and foundations found that the most common reasons for using derivative investments were “meeting fund allocations” and “hedging asset class exposure”. The two most popular forms of derivatives were futures contracts and swaps, which enable participants to increase or decrease a given exposure.

Survey participants were also asked about their perceptions of risk related to derivative instruments. Approximately 80 percent of survey participants viewed OTC derivative instruments as embodying relatively greater risk than their exchange-traded counterparts. Participants cited increased counterparty risk and lack of transparency as the greatest risk concerns, with liquidity risk, misinformation or lack of understanding of the complexities, pricing concerns and operational risk being additional concerns.

Global market, global regulation

The OTC derivatives marketplace is global and cross-border, leading regulators around the world to align their efforts. The G20 nations made joint declarations at the 2009 and 2010 summits, calling for OTC derivatives contracts to be traded on exchanges or electronic trading platforms, and cleared through CCPs—or be subject to higher capital requirements.The G20 nations also agreed to accelerate measures to improve transparency and regulatory oversight of OTC derivatives. The US Dodd-Frank Act and the European Commission’s legislative proposal for OTC derivatives regulation reflect these commitments.

The Canadian Securities Administrators (CSA) Derivatives Committee is working to develop a national framework for derivatives. In February 2010, the committee recommended an effort to ensure CCPs clearing OTC derivatives possess adequate rules and infrastructure to facilitate the segregation and portability of collateral in a manner that provides market participants with appropriate protections. On 31 July, a new OTC rule came into effect in all Canadian jurisdictions except Ontario. The new rule requires disclosure by issuers with a significant connection to a Canadian jurisdiction whose securities are quoted in US OTC markets; and discourages the manufacture and sale in a Canadian jurisdiction of US OTC-quoted shell companies, which the CSA notes “can be used for abusive purposes”.

Quebec in close vision

Quebec passed Canada’s first comprehensive legislation governing OTC derivatives activity in 2009, and updated this legislation in November 2011 to align with G20 commitments. Among other things, Quebec’s derivatives legislation empowers Quebec’s financial markets regulator to monitor the market through information requests and inspections, and enforce market rules through the imposition of administrative penalties.

As the Montréal Exchange is Canada’s primary clearing house for derivatives, Montreal is a hub for derivatives expertise—though much of the derivatives activity has been between the large banks. Despite Quebec’s leading regulatory position, the percentage that is allocated to derivatives in Quebec is perhaps slightly lower than the average Canadian pension plan. Patricia Tonelli from CIBC Mellon’s Montreal office explains why this might be:

“There have been a handful of high-profile issues in Quebec in recent years with hedge funds using derivatives-based strategies. This chilled interest among many pension plans and led to a lower appetite for derivatives products. Now, we are seeing a gradual return of derivatives-type investments as many plans recognise the value of this type of product as a means to both mitigate risk and gain desired exposures in the market. In many cases, pension plans are seeking strategies powered by derivatives such as currency overlay products and LDI strategies that use derivatives models.”

The move to centralise and regulate is welcome, but it is not without challenges. The reporting and tracking that is associated with central settlement and new regulatory frameworks can mean loss of flexibility, increased cost of financing positions, greater reporting requirements and expanded operational requirements. Pension plans are faced with a choice: invest significantly in internal reporting and management systems, or outsource reporting requirements to a third-party provider that can provide the necessary expertise, systems and support.

Best practice trends

With the ongoing march towards expanded regulation, reporting and risk mitigation requirements, and the analysis that has been undertaken around derivatives in recent years, several trends in best practices have emerged for both substantial and occasional OTC derivatives market participants:

• Engage in bilateral exchange of collateral with respect to OTC derivative exposure
• Use forward-looking potential future exposure calculations, which are superior measures of counterparty credit risk than mark-to-market valuations

• Ensure OTC derivatives positions are priced and exposures calculated in a systemic manner
• Ensure robust independent pricing of OTC derivatives to validate collateral demands
• Keep all documentation up-to-date and ensure it captures comprehensive information about OTC derivatives activities
• Conduct regular and frequent portfolio reconciliation with OTC derivatives counterparties
• Establish and apply appropriate counterparty credit limits to control concentration
• Engaging experts with a robust collateral management system will support the effective use of collateral.

Outsourcing collateral management

In January 2011, BNY Mellon released research into OTC derivatives that shows significant gaps in implementation around mitigation of counterparty credit risk, and that substantial investment will be required on the part of many clients with regards to forthcoming regulatory changes and best practices. Key findings included:

1. Forty percent of institutions that were surveyed do not have internal OTC derivatives pricing capabilities
2. Only 10 percent use best-practice potential future exposure calculations for counterparty credit risk measurement—90 percent continue to use mark-to-market valuation
3. Just under 50 percent have outsourced collateral management—25 percent have deployed vendor collateral management solutions internally, with the remainder reliant on bespoke applications and spreadsheets.

 

For some large institutions, effectively measuring and mitigating credit risk across thousands of counterparties may justify building proprietary systems or purchasing a vendor solution. Others are outsourcing the administration, documentation and technology investments that are associated with counterparty credit risk and collateral management to their custodians. As the systems and expertise to support these programmes are aligned with the solutions that custodians have deployed in support of client securities lending programmes, there are notable efficiencies gained that have led some of the largest OTC derivative participants to outsource collateral management.

Even for smaller pension plan managers, the segregation of assets across various portfolios and legal entities, multiplied by current and emerging regulatory demands, can result in substantial operational overhead being consumed in bringing OTC derivatives activities into alignment with risk-mitigation best practices. These factors make the outsourcing of collateral management attractive for institutions desiring robust collateral processes without dedicating substantial internal investment to the issue.

In an outsourced collateral management system, pension plans and their investment managers retain bilateral relationships with the preferred counterparties. A collateral agent is responsible for valuations, margin call calculation, and processing the movements of collateral on behalf of their buy-side clients, while the custodian executes on the transactions and transfers of cash and securities. The outsourced solution enables asset owners, investment managers and counterparties to focus on executing investment strategies, while leaving the operational, regulatory reporting and transaction requirements around collateral management to the custodian and collateral agent.

The upshot

OTC derivatives have become a key tool for a variety of investment strategies, even as the associated operational, regulatory and risk-management requirements continue to grow. The choice of building, buying or outsourcing a collateral management system will depend on the firm’s individual needs. Regardless of your choice, it is critical to work with your investment managers to carefully consider and implement best practices for risk and collateral management around OTC derivatives. SLT

This article originally appeared in French in the May edition of Canada’s Avantages magazine (Rogers Media)

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Guard against these common process deficiencies

Firms should work with their investment managers to ensure appropriate steps are taken against:

1. Inadequate counterparty credit risk governance
2. Weak documentation
3. Extensive manual workarounds for trade management and accounting
4. Dependency on counterparty valuations
5. Limited capacity to accurately quantify counterparty exposures and concentrations
6. Deficient counterparty credit limits and framework
7. Infrequent portfolio reconciliation
8. Limited capacity to call collateral from counterparties
9. Margin requirements that distort portfolio strategies
10. Weak counterparty dispute resolution processe