What is ‘collateral’? It’s a guarantee given by a borrower to a lender for a benefit received from the lender. A guarantee can be in any form like property or physical commodities like gold and silver, among others. For instance, when we apply for a home loan from a bank or any housing finance company, we place our home as collateral by depositing the property documents with them, so that the loan amount received can be disbursed to the property seller. In this context, the property documents represent collateral which is pledged with the lender and stands as a guarantee for repaying the loan amount. In case the borrower fails to repay the loan amount, the lender will have every right on the collateral pledged by the borrower.
Now that we are familiar with collateral, let’s move on to collateral management. In derivatives and over-the-counter (OTC) markets, there are numerous swaps and option deals executed between counterparties and the probability of counterparty credit risk and the risk of default are both always present. Introducing collateral management as a process will mitigate counterparty credit risk, increasing volumes in high risk trades like OTC derivatives and structured products. Based on the daily exposure calculated, counterparties in OTC markets will exchange collateral to mitigate risk of default.
Credit support annexure
Counterparties in OTC markets who wants to collateralize their trades and enter into a collateral agreement will have to sign a formal CSA (credit support annexure) agreement before implementing collateral management. CSA is a legal document that defines the rules for collateral posted for derivative transactions and transactions in OTC markets. CSA is backed by the ISDA (International Swap and Derivative Association) which helps participants in OTC derivatives to form customized agreements and master agreement terms and regulations and follows ISDA as a primary source. CSAs varies from different countries depending on local laws. CSA agreements can be bilateral or unilateral in nature between the counterparties. Once the CSA is signed off by both the counterparties, the collateral management process starts per the agreed start date in the CSA.
Below are a few terms usually mentioned in any CSA:
Base Currency: Margin calls are made based on currency specified in the CSA which is termed as base currency. Counterparty transactions and collateral amounts are converted into the base currency during margin calculation. Usually, USD and Euro are listed as base currencies in CSAs.
Eligible Collateral: Counterparties will only deliver and receive collaterals mentioned in the eligible collateral clause of the CSA. The eligible collateral clause may include cash and securities collateral details like cash in USD and EUR and/or JGB and KRW bonds.
Minimum Transfer Amount: MTA is an amount designed to reduce frictional cost associated with moving small amounts of collateral back and forth. With a larger portfolio, counterparties might consider a bigger MTA since it will be difficult and time-consuming to reconcile and resolve small differences.
Independent Amount: These are the additional exposures set either on a trade or portfolio level on a counterparty. The IA comes into play usually during the downgrade of the credit rating of banks or financial institutions.
Threshold Amount: This is a specified amount of the open exposure that the collateral provider is not required to secure through posting collateral. It’s an unsecured exposure that a party will take against a counterparty. For example, if the net valuation of portfolio of trades outstanding between two parties was EUR 11 million and a TA of EUR 5 million was specified, then the collateral requirement would be only EUR 6 million. Thresholds are either set at zero, a fixed level, or linked to the party’s credit rating. A CSA mentioning a threshold amount for both the counterparties avoids frequent margin calls and collateral deposits whereas a CSA with zero threshold might have frequent margin calls with changes in MTM as a result of which the operational workload increases.
Departments involved in collateral management
There are different teams involved from the inception of collateral agreements till the setup of the CSAs in the collateral management systems. Each department plays a crucial role and communication between different departments plays an important role which in turn helps in framing an effective CSA for both counterparties.
Front office and sales desk
Once the counterparty decides to collateralize trades and enter in a collateral agreement with clients, the first step would be from the sales and front office department to speak with the client’s sales team. Front office also involves on the nature of trades that qualifies for collateral deals. FX deals will usually not be a part of collateral agreements as its settlement cycle is less than two business days. FO plays a crucial role in segregation of high-risk trades on options and swap deals and makes sure that such deals are collateralized.
This is the legal department which frames the rules under which the collateral is to be exchanged and prepares the necessary documentation and agreements. The negotiator works with the legal team of the counterparty and prepares a draft of the CSA. This draft is then sent out to different departments within a bank like the credit officer and the Operations team. If any of the clauses mentioned in the draft is not in favor, then the negotiator will communicate accordingly with the counterparty’s legal team. The negotiator’s role is crucial during the implementation of new CSAs and also during the amendment of existing CSAs. In a few banks, negotiators themselves setup the CSA either in the collateral systems or through a separate legal tool/application which is then linked with the main collateral application.
Credit officers play an important role during drafting of a new CSA and post implementation of the CSA i.e. during the collateral management process. They review and approve aspects of the agreement like IA, TA, and MTA. If clients delay or fail to settle the agreed collateral amount, then the operations team will notify the front office and credit officers so that necessary action is taken. The collateral terms and conditions are either fixed or will be setup based on the counterparty’s credit rating. Whenever the counterparty’s credit rating fluctuates, the credit officer works closely with the negotiator in formulating fresh terms and conditions to cover the new exposures of the bank.
This area falls under the middle and back office department. The Operations team are involved during the formation of new CSAs and the amendment of existing CSAs. The negotiator will send the final draft of the CSA document to the Operations team for their review and sign-off. The team will thoroughly check this final draft and validate all the collateral terms and conditions feasible from an operations perspective. Once the Operations team and other departments provide the sign-off, the negotiator will work with the counterparty and obtain the final copy of the CSA signed between two counterparties/banks. The Operations team will setup the CSA agreement in the collateral tool and based on the start date mentioned in the CSA will execute the collateral contract with the counterparty. A typical day of the Ops team starts with verifying the daily collateral feeds from upstream while the IT team will perform health checks to check the quality of feeds. The Ops team will issue margin call notifications to clients based on the valuation date and the time mentioned in the CSA agreement. Margin calls are determined based on collateral terms agreed in the CSA. If the counterparty’s exposure exceeds the posted collateral, then a margin call will be triggered. If counterparty does not agree with the requested collateral, then the portfolio reconciliation team comes into the picture and reconciles the portfolios of both the counterparties and publishes the root cause of MTM exposure differences.
Latest trends in collateral management
Collateral process has come a long way since its inception. Thanks to advances in technology, many processes are now automated and optimized and helps in better monitoring of counterparty credit risk. In addition to technology upgrade, financial institutes have experienced regulatory changes too.
Banks and investment firms are focusing on the type of collateral which gets delivered to the counterparty. The idea is to deliver the cheapest collateral which will reduce the funding cost of desk. Rehypothecation is another framework which banks have been following for quite some time. However, counterparties can only exercise rehypothecation only if this clause is provided for and mentioned in the CSA. The rehypothecation clause enables the counterparties to repledge securities received as collateral from the client, as well as reduce the funding cost of banks as they do not have to arrange for new collateral from the market. This also enables utilization of existing securities held at different custody accounts for collateral transfers.
If the original counterparty requests for the original collateral to be delivered back, then the rehypothecated collateral will be substituted with a new collateral to ensure the same value of the collateral. Previously this process was managed manually. Now there are automated systems to support rehypothecation and substitution of collateral wherein the analyst will have a clear view of the collateral.
Cloud collateral margining
Banks are moving from legacy based collateral systems to ‘Cloud’ based platforms which is more cost effective for banks in terms of infrastructure maintenance. Further, from a regulatory perspective, banks can accommodate changes much faster when collateral management systems are moved to a cloud platform. Data shows that banks have reduced their collateral management system staff post migration from legacy applications to cloud-based platforms.
Simm model for im calculation
The Basel committee has developed a Standard Initial Margin Model (SIMM) model framework for initial margin calculation on non-cleared derivatives. Per regulatory guidelines, counterparties are now expected to maintain a separate initial margin and variable margin calculation, implying that there will be two margin calls generated, one for IA and another for VM. Accordingly, there will be two CSA agreements having different clauses for IM and VM margin calls. In order to comply with new IM rules, banks and financial institutions will largely depend on a SIMM framework.
Triparty services and automation
Banks are now subscribing for tri-party services with third-party vendors. As part of tri-party services, these vendor companies arrange for collateral transfers, settle monthly interest, maintain exposure, and perform substitution requests on behalf of their clients/banks. Previously, as collateral managers were manually sending margin call notifications to clients by including details of the margin calculation in email or with the help of a collateral tool, the Ops team were able to send margin notices through a single click. Now, collateral managers don’t have to monitor exposures at all– it’s completely automated with AcadiaSoft where in clients are automatically notified to post the collateral. Banks have largely automated the collateral settlement process. Once the collaterals are booked, settlement systems automatically get updated and margin calls settle per the settlement date. Automating settlement systems has led to a decrease in the number of fails per day. Earlier, there used to be a separate Ops team to manage interest settlements of securities deposited as collateral with counterparties. Post automation of this process, there are fewer number of people managing Interest settlements.
Phase 6 of initial margin rules
2020 will witness asset managers and small-size firms making bilateral margining. These small-size firms who have not deposited IM in the past and does not have any operational setup, will see challenges in 2021 when the threshold on the aggregate average notional amount (AANA) drops to USD 8 billion. Firms will calculate AANA in order to determine if they are in scope for the rules; AANA is calculated on average daily notional amount of uncleared swaps. Once the firm’s holding exceeds $8 billion, then the eligible entities will be identified and agreed upon with the counterparties for IM calculation, MTA, TA, haircuts, and eligible collateral. Firms will have to opt for custodian services for collateral settlements and post trade maintenance, market participants will play a crucial role ahead of the Phase 6 deadline. In order to provide small market participants with additional time to prepare for final phase of uncleared margin rules, the Phase 6 2021 compliance deadline was introduced. Analytics and trending technologies might help firms selecting risky and complex trades for initial margin.
Here is a simple example of margin call calculation that currently happens in systems automatically. A collateral analyst will check the margin calculation before requesting the counterparty to post collateral (amounts in USD):
- Exposure 25,000,000 (our Favor +)
- Independent amount 3,000,000
- Net credit exposure 28,000,000(Exposure + IA)
- Threshold 15,000,000
- Collateral obligation 13,000,000(Net Credit exp – Threshold)
- Collateral posted/In transit 3,000,000
- Margin Result 10,000,000 (Collateral obligation – Collateral posted)
- Rounding 10,000
- MTA 100,000
Note: From the above calculation, it is understood that our bank must collect USD 10 million from the counterparty bank. However, if the margin result is below the MTA, than there would be no margin call. In the above case, margin result is greater than the MTA. As a result, there is a margin call for USD 10 million (Figures for Rounding and MTA will be per the CSA agreement; figures shown here are sample figures).