This entry is part 3 of 4 in the series Newsletter Issue VII - May 2012

The Dodd-Frank Act signifies the big­gest US regulatory change in several decades. The main thrust of the legal provisions embodied in Dodd-Frank seeks to correct structural weak­nesses in the US financial industry. More specifi­cally, the reform looks to mitigate the risk posed by activity that falls outside direct regulatory supervision, specifically the bilateral trading and clearing of over-the-counter (OTC) derivatives. Under the Dodd-Frank, clearing for all standardized OTC derivative contracts is to be carried out via central counterparties (CCP) by end of 2012 at the latest. The intent of Dodd-Frank is to instill confidence in the financial markets by boosting transparency and liquidity, and mitigating counterparty exposure concentration.

Although transparency and risk mitigation are the principal benefits of the CCP model, many argue that there are also potential shortcomings. Most obvious, CCPs can themselves become systemically significant institutions, and the failure of a CCP, whether triggered by the failure of multiple clearing members or by inadequate risk management, would represent a very serious market dislocation. Further, the imposition of CCPs may, in the short term, increase exposures faced by market participants. (Duffie and Zhu’s paper ‘Does a Central Clearing Counterparty Reduce Counterparty Risk?’ explores this issue in detail.) Thus, it is argued that the CCP model does not eliminate risk, only restructures it.

Concerns are also raised, from both the buy and sell-side firms, regarding the impact on the overall OTC landscape and how it will change. One of the big challenges for buy-side firms will be managing their existing bilateral OTC derivatives business alongside cleared swaps to gain a holistic picture of counterparty risk. Since not all trades will be required to be cleared, buy-side firms are likely to have both a bilateral book of trades that they are still managing as well as daily collateral calls for the cleared book of swaps. Firms will end up with a mixed clearing environment and operational complexity that they did not have before. In fact, some industry participants suggest that the Dodd-Frank requirements for central clearing of some swaps actually have introduced direct risk into the swaps market.

Collateral management will become increasingly important in a cleared swaps world, where asset managers will be meeting daily margin calls on all of their cleared derivatives positions. In the future, funds will be required to post margin (both initial and variation margin) not only to their brokers, and vice versa, but also to CCPs. Given the anticipated specialization of CCPs by region and product, it may also be required to have several CCP relationships on behalf of each counterparty. Calculating the margin, getting hold of, and then posting the assets required for collateral will be a new and complex process for some firms.

Industry best practices in this area have to date been focused on banks and broker-dealers, while the buy-side firms are only now coming to grips with the full implications of the new requirements. Many question whether the average buy-side firm can ever have what it takes to properly manage collateral within the constructs of a CCP. Even now, many firms still rely heavily on the use of Excel spreadsheets, which are not sufficient enough to handle the diverse complexities of collateral management, especially in environments that require at least five margin calls daily. (A recent research paper published by Finadium states that 35% of all OTC contracts are currently managed by end-users on Excel spreadsheets or other home grown technology.)

To properly support counterparty credit risk manage­ment, a firm’s collateral management system must address two main areas: links to clearing brokers to automate the margin-call process, and enhancements to support the new emphasis on initial margin, which is now required for all transactions. Analysts are predicting that many investment managers and hedge funds will rely on their clearing brokers or prime brokers for technology. However, certain firms, which seek to retain knowledge and control over the process, will still want to run their own collateral management systems in-house – to  verify the collateral calls they are receiving from their clearing brokers via the CCPs, validate received calls and monitor collateral movements.

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