Using collateral to reduce damage

Institutions ranging from asset managers to hedge funds and insurance companies became suddenly more aware of the need to manage the risk of counterparty default.

Frequent users of derivative products, such as asset managers, realised that these instruments – which are very cost effective for hedging risk in areas such as currency, interest rate or credit event – are only going to be valuable if the counterparty they have credit exposure to is able to fulfill their obligations.

“Extreme events such as the Lehman collapse woke institutional investors up and made them realise the importance of counterparty risk,” says David Suetens, chief risk officer at ING Investment Management. “Most people these days have implemented quite robust collateral programmes to protect their clients’ assets.”

REAL TIME VALUATION

Collateral management involves tracking and valuing collateral throughout the life of a trade and making margin calls. If the mark-to-market change of a particular deal or net portfolio position has moved by at least the minimum amount, collateral is then posted or received by the counterparty.

Traditionally, valuation has been done on an end of day basis, but is now moving toward intraday and real time valuation, where possible.

Collateral agreements are often bilateral: the fund manager will receive collateral from the counterparty, such as the swap dealer it does business with, when it is “in the money”, but it will need to give collateral when it is it “out of the money”.

Whether it is in or out of the money, depends on the value of the derivative. The day the fund manager enters into a derivative contract the market value is zero. The value of the derivative fluctuates, depending on the yield curve.

“Normally you agree a relatively low threshold, which means that as soon as you are out of the money, or in the money, you have agreed with your counterparty to wire collateral one way or the other way,” says Mr Suetens.

Asset managers tend to be very conservative when it comes to the form of collateral they want, explains Mr Suetens. Mostly they use cash, as it is very easy to liquidate should the counterparty default. Some managers may accept government bonds, but never equities or corporate bonds, he says.

Depending on the credit rating of the collateral, a higher haircut may be applied. This means that an extra additional margin of collateral of 2 to 5 per cent is required for government bonds compared to cash. The longer the maturity of the ‘govies’, the higher the additional margin.

Collateral management is a risk mitigation technique where counterparty risk is replaced by legal and operational risk, explains Mr Suetens. There is often a timing gap between the moment the value of the derivatives is calculated and the time the margin call is made and received. If the counterparty defaults, the yield curve changes dramatically, and a small part of the exposure may be under-or over- collateralised.

Also, it is crucial to assess the value of the derivatives correctly to be able to make the right margin call, but at times, it is quite difficult to price correctly complex OTC (over-the-counter) derivatives. As to the legal risk, it is paramount that the legal agreement is enforceable by the liquidator.

As in any business decision, the decision to outsource the collateral management process to a third-party depends on a number of variables. “ING IM is a sizeable house, so we can afford to have our internal collateral team and dedicated legal team,” says Mr Suetens.

“A small asset manager may consider outsourcing to a third-party. But even when you outsource, you need to demonstrate to your clients and to the regulator you are still in control and are able to monitor the partner you outsource to,” he adds.

UPCOMING REGULATION

Regulation is likely to affect the business decision on whether to outsource or to build internal capabilities. The upcoming central clearing system for OTC derivatives is seeking to address the risks in over the counter trading by imposing mandatory central clearing for standard derivatives. These deals are negotiated and executed on a bilateral basis and therefore increase the risks on individual counterparties to a trade. Central clearing involves a central counterparty (CCP), which will be highly regulated and supervised, sitting between buyers and sellers.

The CCP absorbs the risks facing individual firms and acts as the ‘circuit-breaker’ in the event of market stress. This will improve the transparency and the standardisation throughout the trade and mitigate risk.

“The market is going through its most significant change in its history and there will be a legal, operational and commercial impact,” says Jason Orben, global product head of derivatives collateral management at JP Morgan Worldwide Securities Services.

Many aspects of the collateral management process are changing, explains Mr Orben. The thresholds – which determine when the credit exposure is great enough to trigger a collateral call – are being reduced, which will result in more frequent collateral calls. If securities are being used as collateral, haircuts will need to be applied, complicating the process.

“On top of that, there is going to be potentially a portfolio of cleared trades as well as uncleared trades. There will be different operational and collateral requirements and different settlement cycles between the two,” says Mr Orben.

“Considering these complexities, asset managers will start wondering whether they will want to invest in their own systems or would rather outsource to firms that specialise in managing the operational process such as major custodian banks, which have already invested in the  infrastructure,” he adds.

Collateral is used on a general basis anytime there is a credit exposure with a counterparty, such as for example in the case of repurchase or ‘repo’ agreements.

“Non financial institutions such as insurance companies, fund managers, hedge funds, especially in the US, are acting primarily as classical cash providers,” explains Stefan Lepp, member of the executive board at Clearstream International.

These institutions give cash to the banks for a certain time, at a fixed percentage of interest, while the banks, acting as borrowers, use their securities as collateral.

Non-financial institutions used to give cash on an uncollateralised basis, but this has changed since the fall of Lehman, says Mr Lepp. Moreover, new regulation aimed at protecting customers, such as Basel III, which strengthens bank capital requirements and introduces new regulatory requirements on bank liquidity and bank leverage, and Solvency III, which concerns the amount of capital that EU insurance companies must hold to reduce the risk of insolvency, are going to further increase emphasis on collateral management.

A tri party repo, as opposed to a bilateral repo, involves the presence of a collateral management agent in the middle, such as Clearstream, which is responsible for allocating and tracking the right collateral – including constant intra-day valuation and adjustment – and making sure that the cash flows are managed in line and simultaneously with the incoming collateral.

The use of a collateral agent leads to a certain improvement in the process, says MR Lepp. However, in case of the default of a bank, the institution, which is effectively the buyer of securities, will have the responsibility of liquidating the collateral.

Depending on the risk profile of the institution, collateral can be government bonds, or corporate bonds with different ratings. Some even accept equities as collateral.

ASSET PROTECTION

“There is significant demand from non-financial institutions for asset protection, who are very concerned that the value of the collateral will fall very quickly in case of a default of the bank, as the market might simply collapse,” says Mr Lepp.

He anticipated that “in addition to the wide range of sophisticated money market products for b2b transactions, Clearstream is currently in the process of evaluating an alternative money market facility supporting the banks to establish a reliable, transparent and balance sheet friendly service model towards non-financial-institutions,” called b2c money market service.

Because of the ongoing lack of trust towards banks and upcoming regulatory changes, the need for liquidity and collateral management services will increase. As liquidity is very tight, it is crucial to expand the range of assets that are eligible as collateral, says Mr Lepp.

Clearstream has added investment funds to its portfolio of asset classes eligible for collateral use and its customers can leverage investment fund shares that are settled via and held by Clearstream to collateralise money market transactions. This move will make available around €700bn of additional collateral, based on the most liquid money market funds managed in Luxembourg and Dublin.

However, the negotiation for what is going to be acceptable as collateral is exclusively between the counterparties.

“Given our fiduciary duty to protect our clients, I would be very reluctant to use funds as collateral,” says Mr Suetens at ING IM. “I need to be the very conservative to protect my clients’ assets. If I used money market funds, I would also have to make sure that I don’t increase tremendously my correlation risk through the underlying collateral holdings.”

Leading up to 2006-2007, clients and markets were focused on yield, but since the global financial crisis, this approach has radically changed.

Collateral management is a risk mitigation technique but also a risk reward decision, emphasises Mr Suetens. Clients are taking a more conservative approach towards techniques such as securities lending or re-use of collateral, he says. They have realised that by giving their consensus that the fund manager may use securities they invest in for securities lending techniques or allow the party who is given the collateral to reuse this collateral, they may gain extra yield, but they also run higher risk.

“We consider collateral management for derivatives and collateral management for securities lending as similar techniques with similar risk, and we need to treat them as one from a fiduciary duty towards our clients,” adds Mr Suetens.

Mitigate risk

• Collateral is used anytime there is a credit exposure with a counterparty to mitigate risk of default

• Collateral management involves tracking and valuing collateral throughout the life of a trade and making margin calls. Collateral is posted or received by the counterparty, if the mark to market change of a deal has moved by at least the minimum amount

• The most used form of collateral is cash, but scarce liquidity and increased regulation may drive expansion in the asset classes eligible as collateral

Clearstream has added investment funds to its portfolio of asset classes eligible for collateral use and its customers can leverage investment fund shares that are settled via and held by Clearstream to collateralise money market transactions. This move will make available around €700bn of additional collateral, based on the most liquid money market funds managed in Luxembourg and Dublin