Over-the-counter (OTC) derivatives particularly those that are not cleared through a central counterparty clearing house (CCP) pose significant systemic risks to the global financial ecosystem. Stringent regulations will help limit excessive and opaque risk-taking, and offset default-related losses to a counterparty, as well as provide visibility into the OTC trading process. The Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) have finalized the Framework for Margin Requirements for Non-centrally Cleared Derivatives to promote central clearing. Even though the framework is to be implemented in phases from September 2016 to September 2020, the impact of this regulation will be felt by market participants across the globe beginning September 2016.
With this regulation, OTC trades will be closely scrutinized by the regulator unlike earlier times when the terms of transactions were mutually agreed upon by the transacting parties alone. As with most regulations, complying with this framework too, will have monetary implication for banks and financial institutions, such as increased capital requirements. As a result, banks need to set aside more capital to fund the requirements of initial margin (IM) and variable margin (VM) on non-centrally cleared OTC trades and haircuts. The European Banking Authority estimates the initial margin requirement for the EU between EUR 200 billion and EUR 420 billion.
Ensuring compliance with the framework
To ensure full compliance with this framework, banks and financial services firms need to focus on the following aspects:
Client onboarding and documentation: Banks and financial institutions will need to renegotiate agreements with counterparties and service providers to facilitate effective collection and segregation of collaterals or margins. Credit support annexes and other collateral documentation will need to be revised to include eligible collaterals, and haircuts, as prescribed by the regulator.
Business processes: Banks will have to establish new business processes, or modify existing ones, to post and collect collaterals. They will need to implement business rules for collateral segregation, and apply haircuts on eligible collateral as per the schedule prescribed by the respective regulatory body. Further, banks will need to analyze the impact of haircuts, and assess potential collateral needs. They will need to reengineer the settlement and exception management processes, to avoid disputes likely to arise as a result of business changes. For example, collateral no longer eligible as per new guidelines will have to be modified by the counterparty.
IT infrastructure: Banks may need to modify their current business models, enterprise architectures, and legacy collateral management solutions to calculate margin requirements, and apply risk-based collateral haircuts accurately. For example, firms will have to create a workflow to identify eligible collaterals, and arrive at their current market value; set up thresholds that trigger variation margin discrepancies, and so on.
Managing Collaterals and Margins Effectively
To ensure compliance with regulations like FRTB, SA-CCR, BCBS 239, and CVA, banks must look at strategic solutions that leverage the confluence of emerging digital technologies.
Blockchain technology: With the OTC derivatives market spread across the globe, and its participants located in different geographies, identifying and processing eligible collateral on time will act as a key differentiator. A distributed ledger system can be leveraged to reduce the latency in collection or posting of collaterals. This could minimize the need for financial intermediaries and manual reconciliation of collaterals.
Real-time collateral and liquidity management system: As high frequency trading gains traction, a real-time collateral or liquidity management solution will provide banks and financial institutions access to real-time data required for effective reporting and risk management. For example, by accessing real-time reports on the collateral received, risk managers can map concentration risks to a specific industry or company. Moreover, in a scenario where crude oil prices are falling, and the bulk of collateral received are corporate bonds from crude oil producers, the collateral management team can request for alternative collaterals from the counterparties to reduce associated risks.
Predictive analytics and BI: A comprehensive solution including predictive analytics will help banks anticipate collateral needs, and manage liquidity more efficiently.
Future Outlook for Non-Cleared OTC Derivatives:
With market participants weighing in on the best way forward, one thing is certain the Framework for Margin requirement for Non-centrally Cleared Derivative is going to change the collateral and liquidity management landscape as we know it. Starting September 2016, the OTC derivatives market is likely to experience increased demand for eligible collaterals and haircuts on collaterals, which will have a larger impact on the values of assets available for delivery. Banks and financial institutions that revamp their IT infrastructure, incorporate evolving digital technologies, and streamline their supporting business functions to comply with the framework are likely to emerge as winners.