With standard OTC derivative trades moving into a clearing model alongside exchange-traded derivatives and even collateralisation of non-clearable derivatives now mandatory, trade repositories are expected to collect information on the nature and value of the collateral posted against open positions on a daily basis.

Getting accurate data quickly will not be easy. From 12 August 2014 financial counterparties and nonfinancial counterparties above certain thresholds must report daily collateral posted against open positions and its value on a mark-to-market or mark-to-model basis. This follows the end of a 180 day extension after 12 February 2014. “As part of reporting, you have to report whether a trade is collateralised or not,” says Joe Halberstadt, head of FX and derivatives markets at SWIFT. “Six months after 12 February 2014, if you are a financial counterparty, you will have to report the mark-to market collateral value of each open trade, every day.”

This applies to cleared and non-cleared trades. As part of its wider remit to mitigate risk in the derivatives markets, EMIR requires that trades are collateralised bi-laterally if they are not cleared. Either way, collateral has to be posted. But which trades have to be cleared is not finalised yet, because the European Securities and Markets Authority (ESMA) has yet to announce the start-date for centralised clearing of swaps in Europe.

“We are not likely to see definitive information on clearing obligations until the back end of this year,” predicts Richard Young, head of regulatory affairs at SWIFT in London. “Even then there will be an extended period while it is approved by the Commission and the Parliament. I cannot see a clearing obligation becoming operational before next year at the current rate of progress.”

However, for non-cleared trades, the obligation to collateralise bi-laterally has started already. The collateral requirements for non-centrally cleared derivatives were set out by the Basel Committee on Banking Supervision (BCBS) and the International Organisation of Securities Commissions (IOSCO) in September 2013, and are being monitored throughout this year. “It is like a Lego set,” says Richard Young. “Various different parts of the building get put up at different stages.”

But both financial and non-financial counterparties are under an obligation to report collateral from 12 August 2014. The 85-field reporting questionnaire contains ten fields to describe the collateral and its valuation (see Table 7, page 42). Some are straightforward (such as the time and date of the valuation, and its currency of denomination) but others are more complicated (such as whether it was valued by mark-to market or mark-to-model). But the biggest challenge lies in the content, rather than the nature, of the questions.

“From a client perspective, the biggest issue they have to Basel Committee on Banking Supervision (BCBS) and the Board of the International Organisation of Securities Commissions (IOSCO), Margin requirements for non-centrally cleared derivatives, September 2013. The DTCC margin transit pilot scheme The obligation to report collateral to trade repositories will test the largely manual processes which still characterise collateral movements. A new utility being tested by DTCC will help.

Under the European Market Infrastructure Regulation (EMIR), fund managers will from 11 August 2014 be obliged to report to trade repositories the collateral they have posted against the exchange-traded and OTC derivatives portfolios they hold with each counterparty, in order to help regulators understand the bi-lateral exposures derivatives counterparties have to each other. At present, the process by which the buy-side collateralises its counterparties (and vice-versa) is not only manual, but effectively retrospective. Failed margin calls, for example, are not picked up until a reconciliation process is run the following day. That is incompatible with delivering accurate reports about collateral posted on trade date plus a day (T+1).

Fortunately, The Depository Trust & Clearing Corporation (DTCC) is working on a collateral automation service which might prove helpful. The project, which is currently in an early adopters program with a small group of broker-dealers, fund managers and custodian banks, was inspired by expectations of a growing volume of collateral movements as the derivatives markets transition from bi-lateral transactions between fund managers and investment banks to clearing through address is where they are going to source that information, and how readily available it is,” explains Daniel Jude, director of client development and sales to asset managers at the CME Group in London. “On day one, when collateral valuation comes in, clients will be looking in-house or looking to their clearing brokers. Rather like delegated reporting, clients are going to be asking, `Who can provide this information? Who do we trust to provide this information? From a compliance perspective, am I happy that someone else is providing this data to a regulator on my behalf, including the reporting of my transactions and the valuation of my portfolio? Do I trust the source of the information, if I do not own it myself?’”

Many fund managers are looking to their fund administrators to furnish them with the data. But Daniel Jude doubts this can survive the introduction of clearing in Europe, whenever it occurs “A lot of clients, especially asset managers, are using their fund administrators to do their mark-to-markets, because the administrator is doing daily collateral valuations for them anyway,” he says. “As we move into the world of clearing, the clearing house seems to be the natural choice as provider of your collateral figure and your collateral valuation figure, because ultimately the clearing house is sending you daily reports on the movement and valuation of collateral.” Jude may or may not be right – he certainly has an interest in taking on the work – but even CME Clearing cannot report collateral for uncleared trades. Bi-lateral transactions that do not pass through a central counterparty clearing house (CCP) are bound to remain administratively painful. Indeed, fund managers, especially of the smaller variety, will be utterly dependent on their clearing brokers to furnish them with the requisite information about collateral, because they lack the in-house systems to capture the data and perform collateral valuations. “The OTC bi-lateral trades, especially if they are exotic trades, are going to be quite difficult,” predicts Jude. It is not the only aspect of collateral reporting that is likely to prove difficult. When trade repositories come to exchange information, different collateral valuation methodologies are bound to clash. “I do not think they can be included in the reconciliation process, because every trade valuation system is different,” says Jude. “All the clearing houses in Europe have different collateral valuation models. In the long term, it is going to be difficult for the regulators to truly have a full understanding of collateralisation without some standardisation of those processes. In the meantime, there will have to be some tolerance levels on the accuracy of collateral valuations.”

The DTCC margin transit pilot scheme

The obligation to report collateral to trade repositories will test the largely manual processes which still characterise collateral movements. A new utility being tested by DTCC will help.

Under the European Market Infrastructure Regulation (EMIR), fund managers will from 11 August 2014 be obliged to report to trade repositories the collateral they have posted against the exchange-traded and OTC derivatives portfolios they hold with each counterparty, in order to help regulators understand the bi-lateral exposures derivatives counterparties have to each other. At present, the process by which the buy-side collateralises its counterparties (and vice-versa) is not only manual, but effectively retrospective. Failed margin calls, for example, are not picked up until a reconciliation process is run the following day. That is incompatible with delivering accurate reports about collateral posted on trade date plus a day (T+1).

Fortunately, The Depository Trust & Clearing Corporation (DTCC) is working on a collateral automation service which might prove helpful. The project, which is currently in an early adopters program with a small group of broker-dealers, fund managers and custodian banks, was inspired by expectations of a growing volume of collateral movements as the derivatives markets transition from bi-lateral transactions between fund managers and investment banks to clearing through centralised counterparty clearing houses (CCPs). On top of existing repo business, and the regulatory stipulation to create separate collateral accounts for each client, and the fact that each and every fund has to meet margin calls separately, the sheer number of transactions might well become unmanageable with a purely manual process.

“We are driving towards a point of multiple margin calls, and exponential growth,” predicts John Straley, Vice President, strategy and business development at the DTCC. At present, fund managers and prime brokers rely on a mixture of email exchanges to initiate and agree margin calls and treasury systems to meet them. The purpose of the DTCC plan is to create a digital margin call confirmation and settlement process across cleared and uncleared swaps and other marginable products that receives agreed margin calls from a matched margin call provider, validates and transforms them into settlement instructions and communicates them to participants to initiate settlement. That is similar to the trade confirmation process in a securities trade. The DTCC has dubbed it a “margin transit collateral processing utility,” or MTU.

To build it, the DTCC is working with the Boston-headquartered technology-based service provider Acadia Soft, which has created a digital margin confirmation service (MarginSphere) that is already used by all of the major global investment banks to standardise margin calls made in the repo, futures and swap markets (and, indeed, trades in the “to be announced (TBA)” mortgage-backed markets in the United States as well, which the Federal Reserve now insists are collateralised, on grounds settlement can be delayed for 30 days. Although MarginSphere had 60,000 active agreements on its network at the start of this year, allowing the sell-side to automate movements of collateral between their respective collateral management systems on the basis of their standing agreements, buy-side participation has remained low. “Many dealers now handle margin calls as a straight through process,” explains Straley. “It flows out of their collateral management system into their treasury system, which issues an instruction to actually make a payment. On the buy-side, it is not a straight through process. Investment managers agree a margin call with a prime or clearing broker, but then have to go to the custodian bank that holds their securities, instruct the fund administrator that records their transactions, and tap funding sources to raise cash, if that is what is required. It is a manual process, conducted by emails and fax messages.”

Inevitably, the buy-side settlement fail rate is high, at three to five per-cent. As the Lehman Brothers debacle showed, collateral often ends up in the wrong account too. To automate the process, the DTCC MTU will centralise the information about any and all marginable activity, and disseminate it to the dealer, the fund manager, the custodian,and the fund administrator in as real-time as practical, so every party receives the information simultaneously and can act immediately. AcadiaSoft will match margin calls between dealers and fund managers, and turn the matched trades over to the MTU, which will then establish a digital margin call record for both parties involved; tag transactions as margin calls; turn matched margin calls into automated, SWIFTbased settlement instructions to custodian banks; enrich the settlement instructions with the Legal Entity Identifiers (LEIs) of the two parties from the pre-Local Operating Units (pre-LOUs) and their standing settlement instructions from the Omgeo ALERT database; track the settlement status of each transaction, to identify any validated collateral movements that failed to take place; and, finally, consolidate and report collateral transactions and positions to all parties.

“Our goal is that the MTU eventually becomes a golden record of collateral activity and potentially segregate balances wherever margin activity takes place. We have a long way to go but, by starting in a relatively simple fashion, we believe we can make it more and more useful to the various counterparties.” In fact, the original intention to add a net settlement process for cash transaction – which would have cut much of the operational risk out of collateral movements - to the proposed agreement confirmation service was deferred once it became clear that it was too complicated to launched initially in the United States and Europe, not least because the Asian markets for collateral are still relatively small. The DTCC has invited members of its working group to commit to use the MTU once it is built.