By Amy Caruso, Chief Commercial Officer at DTCC-Euroclear GlobalCollateral
This past summer, the Federal Reserve in the United States increased interest rates and signalled that this was the first of three rate rises, with one to follow in September and another in December. Likewise, at the beginning of August, the Bank of England raised interest rates, much to the relief of savers.
While rate rises are a sure sign that the economy is strengthening, there are many impacts to the global economy when they increase, which can affect all market participants, both borrowers and savers, across debt and equity markets.
As market conditions change so too can the types of collateral that are pledged in derivatives markets.
For a long period of time, ‘cash has been king’ when it comes to collateral – particularly for both cleared/exchange-traded derivatives (ETDs) and over-the-counter (OTC) bilateral margin calls.
Typically, cash does not require haircuts to margin calls versus collateral settled, and in many markets, it is the fastest way to settle compared to securities. Furthermore, cash does not require substitutions like securities that mature or are liquidated within actively managed mandates.
However, given rate increases and a continued focus on balance sheets, financial institutions may now choose to use their cash assets for other purposes to improve investment performance. This means that firms may need to look for alternative sources of collateral. However, for market participants to efficiently use securities as collateral, certain changes may need to be made to collateral management processing and reporting. These include:
Ensuring that collateral documentation allows for securities to be posted and received. There are some counterparty credit or regulatory reasons that will necessitate cash collateral circumstances, but, where possible, firms should ensure that documentation permits securities as eligible collateral.
Optimising collateral with tools that can select not just the easiest collateral to deliver, but the most efficient collateral to deliver. If planning to use securities exclusively, using a tri-party provider that employs algorithms, which not only value and select collateral, but that can also rebalance intraday, can deliver both operational and liquidity management benefits.
Using a margin call matching and affirmation process that is automated with the collateral selection and settlement process to reduce time from margin call issuance to agreement to settlement.
Ensuring that collateral settlement straight-through-processing is cash/security agnostic. It is important that collateral management system/vendor, custodians, and counterparties can process collateral settlements for both cash and securities with similar ease and efficiency, including confirmation of settlement.
Standardising collateral position reporting in a manner that can be captured by all relevant systems, such as collateral management, inventory/front office and counterparty risk and compliance systems. Normalised data will allow for better reconciliation procedures that drive end of day reporting and compliance functions.
Processing substitutions without operational latency to improve collateral and counterparty risk issues. Replacing and recalling collateral to and from a counterparty requires accuracy of settlement messages that is driven by confirmation of settlement for the replaced collateral that automatically triggers the recalled collateral. This accuracy and automation can reduce counterparty risk by not being over-collateralised for a measureable amount of time and reducing operational latency by not requiring manual intervention between the time the replaced collateral settlement is confirmed and the recalled collateral settlement message is sent to the custodian or counterparty.
While cash may have been king in the past, it is very likely that due to increasing regulatory-driven margin demands and rising interest rates, cash may be replaced by securities as the first choice for collateral in the near future. Market participants should ensure that the requisite workflows and processes are in place to ensure that they are well placed to take advantage of these changing market conditions.