New Legislation Adding Collateral Management for Non-Centrally Cleared Derivatives

The Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commission (IOSCO) have revised their requirements on initial and variation margin exchange for non-centrally cleared over the counter (OTC) derivatives. The new revisions are expected to have broad ranging implications for asset servicing and will specifically affect collateral management.

New BCBS and IOSCO Requirements

In March 2015 the BCBS and IOSCO released their revisions. These revisions began being incrementally integrated in September 2016 and will be fully phased in by September 2020. The most recent initial margin application began in September 2017 affecting entities with aggregate month-end average notional amounts of non-centrally cleared OTC derivatives exceeding EUR2.25 trillion. New variation margin requirements for all entities non-centrally clearing derivatives also began in September 2016 and are now fully phased in.

Collateral Management for Non-Centrally Cleared OTC Derivatives

The new BCBS and IOSCO requirements add a new element for collateral management since non-centrally cleared OTC derivatives have not previously had margin requirements. The new requirements add to already increasing volumes for margin collateral management creating new challenges overall for collateral management servicing.

The new requirements will now extend counterparty risk management and prevention to non-centrally cleared OTC derivatives. Thus, non-centrally cleared OTC derivatives will now be required to post upfront initial margins as well as daily variation margins similar to other types of derivatives.

The BCBS and IOSCO outlined the new margin requirement levels in their March 2015 publication, “Margin Requirements for Non-Centrally Cleared Derivatives.” Margin requirement levels are generated from statistical testing and the identification of one-tailed 99% confidence interval testing. The BCBS and IOSCO provide a schedule for margin requirements that ranges from a 1% initial margin requirement for interest rate products with a zero to two-year duration to a 15% initial margin requirement for commodities, equities and other. Daily variable margin requirements follow a similar methodology for calculation and are based on the varying daily value of the asset.

Collateral Management Processes

Growing collateral management volumes and additional workflow from non-centrally cleared OTC derivatives is challenging the technology systems currently in place. It is also widening the scope of activity in collateral management globally.

In a second quarter 2017 survey report, SimCorp’s publication “Front-to-Back: Optimising Cross-Asset Investment Operations” examines insight from European buy-side firms on current collateral management processes. These firms report a high level of manual processing which is one challenge for the industry. As of the second quarter of 2017, 42% of European buy-side firms are reporting only partial automation and 22% are reporting manual operations. These firms are also showing collateral management technology as a low priority with only 36% of respondentsidentifying it as a popular investment. This infrastructure is expected to challenge buy-side and counterparty relationships as volumes increase and additional transactions get added from new requirements for non-centrally cleared OTC derivatives.

Overall, the global market for collateral managementaccounts for approximately EUR10 trillion. On the opposite side, counterparties also have a range of systems and processes for managing collateral. Institutionalcounterparty collateral management systems are generally more sophisticated. These systems typically include technology for managing collateral by asset class, location, currency and legal entity. Institutional counterparties have also developed efficient interoperability for moving collateral efficiently and have robust data for business, counterparty and service provider reporting.

Effects on Collateral Management

Industry experts believe the collateral management requirements fornon-centrally cleared derivatives could potentially cause collateral management technology to become a higher priority for both buy-side investors and counterparty servicers. The new requirements could also lead to some changes in front office investment strategies as investment officers now must consider the collateral requirements and operational needs involved with using non-centrally cleared OTC derivatives in their investments.Overall, the collateral management industry is expected to see some substantial expansion as the addition of margin requirements for non-centrally cleared OTC derivativesbroadens the scope globally of the currently EUR10 trillion business.

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