This ability to keep hedge funds not only at arms’ length from the ravaging effects of realised credit risks but also to permit them to continue trading at times of extreme market volatility, and with counterparties of varying credit-worthiness, is a critical factor to successful and responsible trading in derivatives, whether exchanged-traded or over-the-counter (OTC). It also happens to be one of the most practical and efficient methods of reducing credit risk and is equally applicable to sell-side and buy-side firms.
It sounds good, so far. However, collateral management is a pervasive form of risk transfer. Monolithic, highly-subjective risks (estimating fair valuations for complex derivatives transactions) are transformed into manifold, more-objective risks (using open market pricing for collateral balances). Get it wrong, or fail to recognise one or more of these transferred or diversified risks, and collateral management could unwittingly increase levels of risk, rather than diminish them.
Collateral Management should reduce not increase risk
Therefore, in one way or another, collateralisation becomes predominantly an ‘operational risk’ management exercise: a highly procedural, middle-office activity involving the simultaneous handling of a large number of ancillary/transferred risks, many of which revolve around the interactions, both electronic and human, with other parts of a firm’s business, their counterparties, their third-parties, external systems, and external sources of data. The task of collateral operations is, therefore, to identify, monitor and manage these risks as efficiently and as completely as possible.
The first hurdle is that collateralisation, even in the smallest organisation depends overwhelmingly on volumes of time-critical, location-specific data from both inside and outside its boundaries, some of it even from third-party providers and sources. Transactions, collateral balances, corporate, market and static data, the list is long (and potentially extensive, depending on requirements), all need to be consumed and collated on a daily or intra-daily basis in order to calculate latest margin requirements. Issues of delivery, timeliness, quality and quantity become key to enabling collateral managers to meet their deadlines. In fact, such are the internal dislocations within some firms’ data delivery mechanisms, publishing margin calls according to their deadlines can be virtually impossible. Even once published, the collateral manager’s job is only partly done, as will be illustrated further on.
Second, collated data needs to be allocated to portfolios according to the terms agreed between the parties, which are variously found in master agreements, credit support documents, term sheets and even within trade specific confirmations. These terms can number in their hundreds, can be driven by credit ratings or net asset values and often need to be both market and jurisdiction-aware. The terms also need to support the algorithms for calculating latest margin calls, which tend to be product specific, and can involve subtle nuances, such as haircuts to be applied to collateral and to be driven by credit ratings and NAVs, and the conditional application of thresholds, minimum transfer amounts and rounding increments in order to arrive at actual margin obligations.
Failure to record these terms completely and accurately can, therefore, easily lead to incomplete, inaccurate portfolios, can also result in erroneous calculations and produce inexact margin calls. Inevitably, in these circumstances, disputes with counterparties will be prevalent and these will further delay or even prevent the receipt of required collateral. Even where collateral managers get these things right, there are many other significant operational issues to handle. Portfolio reconciliation is one of the most obvious and, understandably, a very hot topic at the moment. However, there are others that are equally complex, tricky and potentially resource-heavy ‘features’ for managers to deal with, such as:
- On-boarding of new business, novations of or extensions to existing business
- Dealing with corporate actions and the intermittent cash flows that occur on debt instruments and equities
- Managing collateral eligibility criteria, haircutting strategies and issues around rehypothecation (the unfettered reuse of collateral taken by one party from another)
- Handling collateral liquidity. For example, what happens when a collateral manager notes a net deficit when assessing current requirements to pledge collateral versus expectations to hold collateral? If all counterparties make their calls on time, how will the manager source the full amount of collateral needed for pledging, even assuming his collecting of collateral is 100% successful?
- Accounting for the different jurisdictional taxes that come into play as cross-border and cross-currency collateral activity occurs
- Reporting on a firm-wide basis, not just to risk management, but potentially to trading desks, to the board, to regulators and central banks, and, increasingly, to clients
Over the last few years, industry associations and regulators, alike, have made great efforts to help firms minimise credit risks inherent in derivatives trading, especially through designing legal frameworks that assist in cross-border and cross-product exposure netting. Not taking into account the beneficial effects of this technique of offsetting exposures can create some pretty scary, unrealistic figures.
However, even after netting, it remains the case that over US$2 trillion of collateral is in current circulation, which ISDA recognises to be nearly double the previous year’s figure and yet still remains a largely ‘understated’ and ‘conservative’ estimate (see Appendix 2 of ISDA Margin Survey 2008)). Significantly, collateralisation now happens on a daily, if not intra-daily basis, and, therefore, much of this US$2 trillion is constantly washing around the globe through countless time-critical, cross-border, high-value asset transfers between the collateralising parties. Clearly, such things need expert, harmonised management, not only to ensure exposures are adequately covered, but that delivery occurs with the least delay in settlement, and that parties successfully and speedily ‘perfect’ the purpose of the collateral.
ISDA also points out that an unknown proportion of this overall collateral may well be arising through the act of rehypothecation (the right of a taker of collateral from one of its counterparties to re-use the same collateral to satisfy its obligations to other counterparties). In such circumstances, one collateral position may technically and simultaneously be supporting multiple exposures across multiple parties, even to the point that A gives to B who give to C...who gives to A. It has been seen, aside from the uncertainty about whether some of the current defaulting parties were, indeed, entitled to rehypothecate collateral taken, that such circular activities can cause systemic problems when market crises occur.
Another major, unavoidable challenge for collateral practitioners, since currently more than 80% of all collateral is cash (according to ISDA’s 2007 Margin Survey), is the ‘management’ of interest on cash positions. As with the margin calculations, different markets employ different conventions for compounding, daycount conventions, use of rates, ratings and cut-off strategies. These can all play their part in making accrual calculation and timely statement production and delivery potentially problematic. Inevitably, month-ends can also prove to be very taxing as statements need to be published according to strict schedules, agreed by counterparties within tight deadlines, and payments promptly made.
Risk mitigation – finding the Achilles Heel
Accordingly, for all the above and more, it is easy to appreciate that hidden within the simple mechanism of converting ‘exposure’ into ‘collateral’, lie many new risks, of which legal, documentation, calculation, data delivery and quality, non-affirmation, pricing, settlement are just some. However, what has been written so far concerns, in the main, the internal operational mist that swirls around the real challenge for current and future collateral management – transforming the way collateral managers communicate and interface with each other, their custodians and their brokers. This is where the processes and methods are at their least resilient and the point where risk mitigation is at its most vulnerable. In fact, it should be the very opposite, since it is through these interfaces that the conversion of ‘exposure’ into ‘collateral’ literally happens. Such is the general lack of resilience here that it could call into question whether collateral management is an effective, pragmatic solution to the real dangers of credit risk, as the current state of the global markets proves.
How does it work at the moment? Well, here’s a hypothetical, yet fairly standard exchange, which illustrates the difficulties. Party A’s collateral management system, which might be nothing more than a spreadsheet, calculates a margin requirement against Party B and prompts the user to fire an email to Party B. The email probably has two attachments, a pdf of the call notification and a spreadsheet detailing A’s latest portfolio of collateralised transactions, which has given rise to the margin call. What happens next? Did B even receive the email? The fact is A doesn’t really know, and, in any case, these sorts of emails are often delivered to a distribution list (e.g. collateralmanagement@partyb.com). Therefore, who, if anyone, picked up the email is generally unknown: even a returned ‘delivery receipt’ proves little in the context of large organisations and central email servers. Even assuming successful delivery, has B compared A’s margin call yet, given that the deadline for a response is fast approaching; indeed, will B respond at all, and how will its response be ‘delivered’? At this point A, worried that it is not going to get the collateral required, picks up the phone to ‘follow-up’. B answers to give its figures over the ‘phone and confirms that a reply by email will arrive shortly, only this time the portfolio is delivered as a pdf and the response, which disputes A’s figures, is embedded in the email itself.
Unfortunately, A’s collateral management system is not capable of handling inbound emails, nor detaching, processing and automatically reconciling the two versions of the portfolio...time is ticking away, and yet there is still no agreement for B to transfer collateral...so it goes on, eventually and hopefully leading to similar, distended exchanges between A, B and their custodians and brokers regarding actual collateral transfers. A number of new, unacceptable risks have been introduced:
- No standards for communications, whether messages, formats or contents
- No protocols for communication transport mechanisms
- No provisions for security and encryption
- No ‘SLA’s for fault-tolerant, deadline-aware margin management
The latest statistics from ISDA show that collateralisation now covers over 60% of credit risk exposure in OTC derivatives (up from a mere 29% in 2003). Whilst this is undoubtedly good news, it also indicates that as volumes grow and as techniques diversify, there is a critical need within the market to create an open, secure and resilient messaging platform that will not only enable near zero-touch collateral management, but also ensure that act of risk transfer and diversification does indeed lead to significant risk reduction.
This is by far the greatest of all the operational challenges for 2009 onwards. Such a platform, which needs to be equally applicable and useful to buy-side and sell-side firms, will remove the current high levels of uncertainty and degrees of manual processing. It will introduce easy-to-adopt standards, and potentially allow the majority of margin calls within the market not only to be acknowledged automatically, but also approved and collateral exchanged with little or no human intervention.
Simon Lillystone specialises in designing and building technology solutions for collateral and margin management (CMM). He joined Allustra, a small, London-based software house, as Director of Business Development. He has helped bring Allustra’s leading edge solution, Kyros, to market. Allustra was recently acquired by Omgeo
