The OTC derivatives and eligible collateral challenge

Ian Mainwaring, Senior Consultant, Citisoft

There are many current investment management challenges where a metadata-centric approach can be applied to ‘ease the pain’. One of particular concern at the moment is handling the collateral requirements of OTC derivatives when cleared through central counterparties (CCPs).

The requirement to clear OTC derivative transactions via defined central counterparties is among the many strands of the wide-ranging Dodd-Frank and EMIR regulations. It is anticipated that these CCPs will impose a fairly tight regime with respect to eligible collateral and if an organisation clears through multiple CCPs, more eligible collateral will probably be required due to the possible loss of netting opportunities. It is also likely that CCPs will adopt a conservative approach to what is permitted as eligible collateral (e.g. cash, high-quality sovereign debt). These factors will put further pressure on organisations to manage their ‘pot’ of eligible collateral more effectively.

The actual specifics of eligible collateral, how re-hypothecation may be used and whether there will be any co-operation between CCPs to provide inter-CCP netting, are all factors that are yet to be defined.

Given the uncertainty of the rules of the game being played on this new field, are there any ‘knowns’ that can be addressed and what can technology and collateral management systems do now to position themselves to support these future requirements?

The following are some basic consequences in support systems that can reasonably be anticipated from the clearing of OTC derivatives through defined central counterparties:

• an Increased number of external interfaces – potentially with multiple CCPs;
• a Collateral Management System (CMS) becomes a necessity;
• the location of a CMS in the front-to-back business process flow will change;
• the reporting required from a CMS will increase in scope and complexity.

The metadata response
So, how can the use of metadata minimise the impact of these consequences? Well, fundamentally, all four of the above points can be summarised as being either:
• an increase in the number of system interfaces, both internal and external, or;
• enhanced reporting requirements.

These can be further summarized as ‘more dataflow’. That is: more data to be transferred, and more useful information to be extracted from more sources. And as the number of data sources being managed and the amount of data being transferred increases, the need to know what is moving, what it means, and what is happening to it on the way also increases. The most effective way to do this is to make use of metadata structures to:

• clearly identify and describe the data that is in the scope of the business (a ‘canonical’ or ‘logical business model’ view of the data, allied to a data dictionary for the descriptions);
• describe and document data flows and transformations so that the progress of a data source item to its target report(s) can be traced, or the derivation of a reported value from its components can easily be checked (known as ‘data lineage tracking’);
• link data sources and extracts to the logical business model data items that they contain (creating a framework in which rapid Model Driven Development can occur);

In the case of new support needed for OTC derivatives, the impact of using a metadata structure to support analysis and development will be:
• the use of internal canonical models will facilitate integration between internal systems because equivalent values in the systems are linked, and ‘gaps’ or differences are easily identified;
• data lineage analysis will accelerate the definition of enhanced collateral reporting requirements, as it is far simpler to trace the source of required values and replicate (or amend) their use in the new output;
• Model Driven Development tools will speed up the development of new interfaces and increase the speed of reaction to changes required in existing interfaces.

Without the use of these concepts and techniques, the challenges imposed by the increased collateral management requirements can still be addressed in more traditional ways. An investment in a metadata-centric solution, however, not only facilitates support of the new collateral specific requirements and allows changes to these requirements to be accommodated, but it also lays foundations to support future initiatives and changes.

Taking the metadata route therefore offers significant benefits not only by facilitating a particular solution now, but also by providing a strategic framework that will provide long-term benefits for investment managers.