Dodd-Frank’s Effect: Collateral Management Moves to the Front of the Line

June 1, 2011

Prior to the financial crisis of 2008-09, for many firms collateral management was a low-brow function entrusted to Excel spreadsheets; and often sorely neglected back-office operation. The collapse of several investment banks has proven the benefit in having a strong credit risk monitoring mechanism in place; and the collateral management function has assumed a greater importance in an investment management firm. The Dodd-Frank Act, which was passed in July 2010, is another important event that has had a significant impact on the way firms handle their collateral management.

Central clearing, a major element of the Dodd-Frank Act, requires OTC trades to be matched in a third-party clearinghouse much like exchange-traded futures contracts. The new regulations press for greater efficiency by means of strict time limits for the collateral process and dispute resolution. Fund managers must reconcile multiple counterparties, make margin calls and optimize their use of collateral. They need to keep track of just what collateral they have posted with which broker-dealer counterparty or clearinghouse as well as the collateral requirements of each clearinghouse (using the cleared model can mean sending collateral positions to multiple central clearinghouses). This tracking and related calculations must be made in close to real-time, since the clearinghouses will be posting their collateral requirements daily. Fund managers must now automate their middle and back office processing work for OTC derivatives and license (or build) connectivity, valuation, and collateral management software.

Industry best practices in this area have to date been focused on banks and broker-dealers, while the buy-side firms are only now waking up to the full implications of the new requirements. In the last 12 months IntegriDATA (business technology consultants and third-party collateral management solution provider), has had active discussions with over a hundred buy-side firms (various sizes and business nature). There is certainly strong awareness of required operational changes among the fund managers, and many are seeking to [further] automate their collateral management process. IntegriDATA is seeing increased emphasis on the automation of such key functions as valuation, reconciliation and collateral management.

Firms also realize that margin and collateral implications will continue to become an increasingly larger component of the front office and risk management equation as a much broader range of constituencies within a firm – including risk and senior management – will use the information coming out of the collateral management system. For example, to respond to the new Rule 204(b)-1 that requires maintenance and disclosure of certain categories of records and reports, firms will use a collateral management system for reporting data on positions. In the front office, information on the collateral process can be used far more as an input into decision-making processes, and may be integrated into, for example, the liquidity policy.

It is important to point out that new regulations will affect all firms regardless of size – even if smaller managers plan to rely on size exemptions, consultants and institutional investors will likely insist before investing that buy-side firms have thought these issues through. The buy-side firms will need to have comprehensive collateral management systems that are able to capture and reconcile all relevant data, and to do so in real-time.