Fredrik Ekström, President, Nasdaq Clearing
Regulations – and particularly the OTC derivatives reform – have heightened the need for efficient use of capital. Central clearing for derivatives means that many buy-side firms are facing new collateral challenges and, as a result, portfolio margining has emerged as an important solution. However, regulations will harmonise margin levels so portfolio margining will cease to be a differentiator. To stay competitive, firms are already beginning to search for new and innovative ways to do more with less.
Collateral will continue to play a crucial role in this. As regulations drive demand for high quality assets, firms need to optimise these in ways not related to margin. Therefore, while the concept of collateral management is nothing new, firms are tackling it with greater sophistication. Increasingly, this is going to involve managing the flow of collateral and balance sheet usage more intelligently.
The industry must also contend with collateral bottlenecks resulting from weaknesses in financial market infrastructure. Clearing houses have an important role in mitigating these weaknesses and can do so through delivering a number of enhancements to participants. These include direct access to market infrastructure providers, real-time information, straight through processing (STP) and the auto allocation of funds on a client level.
Getting the management of collateral right, and removing the bottlenecks,means firms can improve the overall management of supply and demand. It also facilitates more accurate forecasting, deeper insights into collateral shortfalls and more efficient allocation between bilateral and cleared trades. Furthermore, by avoiding over-collateralisation, they can free up valuation liquidity.
Brokers are helping clients make better use of their assets but both are also turning to CCPs for other opportunities. This includes cash optimisation, with total netting across all cash flows and full STP. This applies to the entire cash flow, from instruction and confirmation to reconciliation of individual transactions.
Cash optimisation involves moving all monies, including initial and variation margin, fees and premiums, into a single cash transaction.Firms can then perform calculations that take into account all cash transactions and all posted collateral. This allows them to make smart decisions about how to apply those funds,such as using any excesses in one area to offset a deficit in another. For example, excess initial margin could be reallocated to cover a deficit in variation margin.
For all of this to work, a set of key principles has emerged to help define some of the more technical aspects. One of these is ensuring there is no double funding in respect of initial margin, variation margin and cash settlement. Another is that the same day value applies for automated cash call backs and direct debit functionality, on both house and individual client account levels, regardless of currency.
These and other technical details will likely evolve as cash optimisation techniques become more widely adopted. However, this is just the beginning. After cash, there are further opportunities such as security optimisation and improving the use of collateral in tri-party arrangements. Tri-party arrangements will be an important tool to optimise the allocation of collateral between CCPs but also between bilateral and CCP margin requirements.
Paving the way for innovation
Making these and other forms of collateral management a reality is going to depend on several factors. Perhaps the most significant is technology. Automation, standardisation and anything that improves efficiency will be vital to enabling greater innovation. This includes developments in connectivity and the continual drive for STP, such as T+2. If firms can’t move collateral efficiently, any level of sophistication applied to optimise it will have a limited impact.
Reducing and even eliminating manual interventions of flows between participant, client and clearing house is going to benefit the whole market. This impetus could well push through the standardisation of FIXML, FPML and Swift-based messaging. Greater automation would also pave the way for other offerings. These include direct debit or credit transactions that automate the paying back of any cash surplus on a member’s account.
In a more competitive clearing landscape, where market participants have greater choice, innovation in all forms will play a major role. Participants will be looking for the best ways to make efficient use of collateral as well as the firms best equipped to deliver them. What’s important though is there can’t be a one-size-fits-all approach – participants will need tools that meet their specific needs. Above all, they will want access to new innovations and developments – whether that’s tri-party offerings, security optimisation or something else entirely – that will continually keep them one step ahead.