Webinar: The regulator says it is time for fund managers to measure, mitigate, manage and monitor outsourced operational risk

AUDIO: An audio replay of the Webinar. Click on the 'Play' button to listen.

The introduction of mandatory OTC derivatives clearing is forcing fund managers to take more control of how they administer their collateral. In order to clear trades through central counterparty clearing houses (CCPs), managers must post high-grade collateral through both initial and variation margin. Appointing an independent agent to help manage your collateral appears to be the route most managers are going down in this new regulatory environment.

Here are some of the key findings from a webinar held by COOConnect’s on these issues:

• There has been widespread talk about a collateral shortfall with some estimating it could be as high as $10 trillion. Despite a report by the Bank of International Settlements (BIS) stating otherwise, the risk of a collateral shortage is something financial institutions need to take seriously.

• Demand for high quality assets will be heightened when Basel III capital requirements force banks to bolster their holdings of high quality, liquid assets. Meanwhile, Dodd-Frank and the European Market Infrastructure Regulation (EMIR) will force firms transacting in certain over-the-counter (OTC) derivatives to post high-grade collateral to CCPs. It is vital banks and financial institutions including the buy-side optimise their collateral holdings in order to avoid “a collateral log jam.”

• There is a possibility that several banks could come together to create a utility aimed at helping firms manage their collateral. However, in the near term this is inhibited by politics although hopefully this will be resolved.

• There is uncertainty about how many CCPs will exist down the line. Some argue it is essential there be multiple CCPs operating in the market so as to mitigate concentration risk. Others have expressed concern excessive competition could facilitate a race to the bottom in terms of CCPs easing the eligibility criteria for collateral posted as margin to CCPs in an effort to win more customers. CCP criteria for collateral eligibility vary so it is essential firms have a system in place to ensure the right collateral is posted to the right CCP.

• Siloed technology infrastructure means most firms do not have a great handle on their collateral. It is essential to have an enterprise wide system, particularly for firms with a global reach, to attain optimisation of collateral.

• Fund managers have yet to think about collateral optimisation, mainly because the full impact of clearing has yet to be felt. Fund managers need to create a centralised collateral management function in-house rather than have it siloed across divisions.

• Firms offering tri-party collateral management services are nervous about upsetting banking clients if they pursue fund managers.

• Clearstream sees itself as mobiliser of collateral although it is trying not to dis-intermediate the banks. However, this reluctance to dis-intermediate the banks could mean the whole process is quite costly.

•Fund managers do not necessarily have to appoint a collateral manager in addition to their custodian. The custodian already performs a lot of these functions, particularly around collateral mobilisation.

• Asset managers must ensure they are being efficient with collateral during the pre-trade process. They need to look for efficiencies at CCPs. Historically, this was irrelevant but this is no longer than case.

•Fund managers are not well prepared in terms of their technology to manage their collateral. They do not have a single collateral inventory, for example.

•Hedge fund managers could be onto a winner. The netting of the required margins for the CCP will be “super- efficient” for hedge funds.

•The emergence of prime custodians which offer prime services from a custody perspective means hedge funds and asset managers will have two relations with traditional prime brokers and prime custodians. Question is who provides the collateral management service.

• There is an opportunity for pension fund managers which have a high quality inventory of collateral.

• Guaranteed portability is no longer the case, and collateral transformation is no longer on offer as much. Now, banks have retreated from collateral transformation upgrades as only a handful of banks have sufficient balance sheet capital to offer the service. One panellist cited HSBC as an example of a bank that was well-adjusted to handle collateral transformation upgrades.

• Custodian banks will probably go into collateral management. There will be a cross-subsidised business model in order for this to happen at the banks.

• Fund managers are renegotiating CSAs with their banking partners as clearing approaches. Many of these CSAs were struck years ago, as they are out-dated.

• Fund managers are going to take on more costs. Most fund managers are loath to pay for collateral management. Many firms are offering collateral management as part of a bundled service at the custodian so the costs are less clear-cut.

• It is strongly advised managers outsource their collateral management.