Almost a year on from the start of mandatory central clearing in the US, buyside funds are shifting their attentions towards optimising their collateral functions to alleviate the burden of posting billions of dollars worth of margin against cleared derivatives trades.
Banks have long predicted collateral management would become a vital service for swap end-users, many of whom are now having to handle daily margin calls for the first time. Margin efficiency fell by the wayside last year as buyside firms concentrated all their efforts on the compliance and operational nightmare of mandatory clearing, but this looks set to change.
“Now that we’ve got most of our books going through clearing, it’s apparent we’ve got to optimise the way we post collateral,” said the head of operations at one major US fund. “We’ve known for awhile this would come up but we are just now starting to have serious discussions with our clearing banks about what they can provide.”
The bulk of US end-users began clearing swaps for the first time in mid-2013. Some teething problems aside, the transition went smoothly and clearing is now in full flow. Last week, LCH SwapClear reported it had surpassed US$100trn in client notional cleared for interest rate swaps.
Now, as the dust begins to settle on the most significant overhaul in the history of the US swaps market, clients are focusing on operating with greater efficiency in the new trading environment.
How they go about doing this depends on the end-user in question. For instance, firms with larger derivatives liabilities – such as insurance companies with structural one-way positions – will have larger collateral demands, compared to hedge funds that may have partially offsetting long and short exposures.
Meanwhile, clients with large cash balances or assets that can be readily posted at clearing houses – such as top-rated government bonds – may not need as much assistance as firms with portfolios of assets that are not widely accepted at CCPs, such as lower-rated corporate debt.
“Swaps clients are beginning to look at the collateral enterprise holistically, centralising collateral operations and getting their heads around what costs are going to be,” said Nadine Chakar, head of product development and strategy for global collateral services at BNY Mellon, which holds US$28trn in assets under custody.
“They’re starting to figure out the intrinsic value of each trade so they can know whether a specific trade is economically sensible given collateral requirements and their internal capabilities.”
Such services aim to address fears of a potential shortfall of high-grade collateral as standardised swaps are pushed into CCPs and heftier margin requirements are levied on bespoke trades. Private and public sector estimates have put the collateral drain at anywhere between US$500bn and US$10trn as a result of these measures.
The start of the US clearing mandate helped spur a migration of US$500bn of collateral from uncleared swaps to cleared trades from 2012 to 2013, according to the latest ISDA margin survey. Collateral demand is set to grow further as European clearing kicks in as early as this December and uncleared margin rules go live in late 2015.
As well as sourcing the necessary collateral, some end-users need assistance coping with the increase in the frequency of margin calls, which could jump by as much as 1,000% on the back of these changes, according to a recent whitepaper from the DTCC.
Ensuring they are posting margin in the most cost-efficient manner is another area of focus. Major dealers are developing a number of capabilities to help clients. According to Kelly Mathieson, head of collateral management at JP Morgan, this includes changing the sequencing of margin calls, providing data to help reduce counterparty credit risk when a portfolio spans multiple clearing banks and clearing houses, and monetising the lending value of assets that would otherwise have been encumbered as margin.
Participants also signal there is work to be done at the clearing house level to ease the collateral burden for end-users. Some CCPs have reacted by broadening the range of assets accepted as collateral. Eurex includes blue-chip equities in its 25,000-strong eligible collateral list for client clearing, while CME Group has has extended the list of eligible collateral beyond highly-rated government bonds and cash to assets such as gold and corporate bonds.
Jack Callahan, group executive director of OTC products at CME Group, said many clearing banks are now making sure they have the necessary legal and operational requirements to allow for these tri-party custody arrangements to work, which enable buyside assets to filter through to the CCP in an automated manner.
“Posting those assets to CME Clearing which are traditionally part of the client’s portfolio, enables them to reduce the amount of performance drag on their portfolios that would occur if they had to sell their existing assets to raise cash,” said Callahan.