Much work remains for a transition into the additional phases of a collateral management system. That was the conclusion reached by a panel of industry experts during the 2018 Collateral Management Forum in New York, hosted by DTCC-Euroclear Global Collateral Ltd. (GlobalCollateral).
Moderated by Deborah North, Partner at Allen & Overy, the panel Deep Dive on Collateral Management Ecosystem, included industry experts from various backgrounds.
Key Issues Remain
The custodial relationship and its addition to the bilateral negotiation in collateral documentation has been a focal point for regulators. The right relationship is crucial to a more secure initial margin exchange. If the custodial relationship is not done correctly, the panel concluded, the risk of exposure would be characterized by the possibility of more collateral being delivered that could become part of a termination payment.
The moderator asked the panel to explain how a firm can determine if they are in scope for phase four or five. As one panelist explained, it’s important for dealers and asset managers to understand whether an entity is in scope and that is determined by whether you have material swaps exposure and that is based on the Aggregate Average Notional Amount (AANA) calculation.
There are many different types of entities that need to be considering this (in scope) issue and they all have sorts of their own special flavor. There might be standalone individual entities that may have material swaps exposure and for them, it’s an analysis for just that one entity. Or there may be an insurance company with an asset management affiliate that has seeded funds. And separate accounts with multiple asset managers need to compile their AANA and communicate that to each asset manager and to each respective dealer counterparty.
The key, as one panelist explained, is that firms must manage the flow of information within their own organization, with clients, and with counterparties to determine if they are in scope.
Importance of the Custodian
As the market seeks agreement on the spectrum of collateral that would be eligible for the exchange of initial margin, the panel emphasized the importance of the custodian in the exchange.
One panelist stressed the importance of the custodian in the ecosystem because it will help bridge the gap between these different ways of exchanging initial margin, both in the direction from dealer to buy side and buy side to dealer. The topic of triparty vs. third party segregated account structures was discussed as a means of the two – and the two types of providers – to work together; some legal entities will post from a triparty structure with collateral valuation, selection/optimization and settlement provided and some will choose a custodian with a third party segregated structure where the counterparty still provides valuation and selection.
Creating a security interest with collateral posted via a custodian was a highlight of the relationship that will be created with the initial margin segregation requirements. Further, the need to have a digitized collateral schedule in the documentation can ease operational efficiencies into the future, and having streamlined collateral schedules can help reduce the heavy lift of the implementation as well.
Which Model to Use?
One panelist reviewed the differences between the standard grid initial margin and the Standardized Initial Margin Methodology (SIMM), including the cost of building and maintaining the initial margin calculation process and the cost of posting collateral. For many firms who have done the analysis, using the industry-built SIMM will be cost effective from a collateral posting perspective as it allows for offsetting risks. In contrast, there are some legal entities that have little to offset or minimal number of swaps, then the standard grid may be most efficient. Jurisdictional variances can also impact the decision making process for choosing an initial margin method.
Once the model is chosen, or models if there are jurisdictional variances involved, then the implementation should include using a utility-based dispute resolution service to reduce counterparty risk and operational challenges. AcadiaSoft worked with TriResolve to develop such a service that is used by a vast majority of Initial Margin Wave 1, 2, and 3 entities. Proper coordination ahead of initial margin implementation, not only to determine the risk sensitivities, but the portfolio of trades and categories of the trade types will help reduce the number of future disputes.
In an effort to make the documentation process more efficient for negotiating and capturing data terms for Credit Support Annexes (CSAs) between counterparties and Account Control Agreements (ACAs) with triparty providers and custodians, panelists shared suggestions of tools that are being piloted. The group focused on how various solutions need to be interoperable to ensure that there isn’t bifurcation of solutions or duplicate efforts needed.
The group urged the audience to begin planning soon - if they haven’t started already – even if they are likely to be in Wave 5 in 2020 and to use the learnings from Wave 1, 2, and 3 entities and industry solutions and utilities to make the implementation as streamlined as possible.