On June 30, 2010, and July 15, 2010, the U.S. House of Representatives and the Senate, respectively, passed the Dodd-Frank Wall Street Reform and Consumer Protection Act. Earlier this year, some industry sources estimated that the new regulation will mandate up to 60 percent of OTC contracts to be centrally cleared over the next two to three years. As the focus on implementation and increased usage of central counterparty (CCP) clearing continues, firms recognize that the shift will have a significant impact on collateral management. Besides the uncertainty about what instruments will be considered standardized, market participants are concerned about how clearing will work and affect internal trade processing operations and risk management functions. Per request of our readers, this article covers the main operational changes firms will have to make to use CCPs, and the key areas to consider when making operational decisions.
How Trading Worlds Differ
Margining is a key element of derivative trading. In the central clearing model, as opposed to bilateral trading, a clearinghouse acts as a central counterparty to all of its trading participants – it collects margin from firms to ensure that they meet their contractual obligations. If they cannot, the clearinghouse has legal claim over the assets of a defaulting participant. The clearinghouses are meant to protect all derivative participants from the default of a trading counterparty, and thus greatly reduce the counterparty credit exposure that currently exists in the bilateral OTC derivatives model.
Effect on the Back-office Operations
Two key provisions of the recently passed legislation are (1) central clearing and (2) data collection and publication through clearinghouses or swap repositories. Parties are required to post collateral every day; and provide real-time, or at least, intraday reporting on fund transfers and variation margin. OTC contracts will need to be valued at least once a day to determine the accuracy of variation margin.
To support these requirements, on a daily basis fund managers will need to perform highly data intensive processes i.e. portfolio position reconciliation, margin calculations (capturing, computing and comparing data from the clearinghouse or its clearing member against the internal accounting records; as well as validating clearinghouse’s or clearing member’s calculations), margin calls and addressing valuations with counterparties.
When it comes to intraday reporting of funds transfers, a clearinghouse or its clearing member (DCM) will require access to some type of an automated system that captures and stores the details of the transaction between the counterparties. Clearly, such system should be able to handle electronic signatures, affirmations and confirmations.
Maintaining Relationship with Multiple Clearinghouses & Brokers
It is important to highlight the fact that as there may not be one CCP that spans all instrument types, a firm may need to manage exposure and collateral with multiple clearing brokers (DCM) and multiple clearinghouses. Most participants will have more than one DCM regardless of whether they work with one CCP or many. This means multiple message formats and different valuation methods used by each clearing broker and clearinghouse.
We discussed possible downsides associated with dealing with [multiple] clearinghouses with Darrell Duffie, professor of finance at Stanford University. “The new regulatory clearing requirements are likely to raise demands for collateral significantly. This is for two main reasons. First, dealers had sometimes allowed large highly rated counterparties to post little or no collateral. Many of those positions will go to CCPs, which [I hope] will have high collateral requirements. Second, as shown in [my] recent research with Haoxiang Zhu, the loss in bilateral netting caused by clearing will more than offset the gain from multilateral netting at CCPs, unless and until a significant amount of clearing is done via relatively few CCPs. With the resulting increase in average exposures, most of those who post collateral will post more of it. In addition, collateral requirements for non-cleared derivatives are likely to increase. [I believe that] mandated clearing is a good idea for large users of standard derivatives, but it could end up badly if there are too many CCPs, or if CCPs are not stringently regulated,” commented Mr. Duffie.
Data and Technology Challenges
With the new regulation, CCP is another player that has been added to the derivatives processing equation. This means further reconciliation of positions between the fund managers and the broker dealer, and the broker dealer and the CCP. The changes will affect how post-trade functions such as reconciliation, collateral management, margin calls and valuations are handled.
Currently, automation is seriously lacking (primarily due to source data limitations) and collateral management remains the ultimate data management challenge for the industry. In recent research, conducted by IntegriDATA, almost 40% of buy-side firms admitted that they do not perform such key control processes as reconciling collateral, verifying margin and matching derivative holdings on a daily basis. For those firms that claimed to perform these processes regularly, the effectiveness of their processes can be questionable given the industry wide pain points with respect to broker data (e.g. files not leverageable for data extraction, non-standard layouts/formats, lack of standard financial instrument ID’s).
Although some are taking the “wait and see” approach, by the time the rules of clearing are defined, the industry at large is expected to be prepared to trade electronically, clear centrally and report to a trade repository. Those fund managers that have not yet automated the reconciliation of positions need to do so. And all fund managers need to ensure that solid procedures, interfaces, infrastructure and operational processes to support new requirements are developed. We would recommend that firms determine where their gaps lie, set priorities and build out a plan for process improvement. Certainly, the build vs. buy vs. outsource decision should be addressed early on because that will drive a lot of your actions. The challenges for small and mid-size fund managers will be far more difficult than for large players with deeper pockets. If you asked for a single recommendation, we would go with the old adage, “possession is nine-tenths of the law”, and work on automating data capture – where you get the biggest bang for your buck.