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As counterparty risk is crushed, operational risk rises

11 December 2018

Firms need to optimise their internal processes and implement new regulation required processes if they are to reduce the operational risk of managing collateral for uncleared derivatives trading.

The management of counterparty risk through central clearing has a strong precedent in the Lehman Brothers' default of 2008. A central counterparty (CCP) - in that case LCH - was able to support clearing members by trading out of the bankrupt broker's positions, preventing counterparties from taking a hit from the default.

The successful intervention during that event, and its mitigation of systemic risk, triggered the support from G20 countries to mandate the use of CCPs to manage counterparty risk for the majority of derivatives trades. It also led to support for the use of collateral to be held against positions, whether cleared or uncleared. By holding cash and securities as collateral to show they can cover the initial cost of a contract via initial margin (IM) and separately exchanging margin to cover the daily changes in the contract price through variation margin (VM), counterparties have a buffer against a counterparty default.

However to facilitate this collection and management of collateral they also need to track and move securities or cash, more than they have ever needed to before. That creates its own challenges.

"Regulation has moved counterparty credit risk into league with operational risk, for sure," says Rob Scott, Head of Custody, Collateral & Clearing, at Commerzbank. "Now there is a lot more accountability on the front end, with balance sheet management, the need for limits and other controls that are in place. It's seen as a commercial advantage if you can pull together your collateral management, organise it, and centralise it. Having collateral managed properly, valued correctly, and mobilised across your worldwide operations is key."

That commercial advantage is a big 'IF' and where many capital markets businesses need to focus their efforts. The question for most firms, across both buy and sell side, is how to ensure they are moving to this new way of operating, without creating more complex processes that increase other risks, whether operational risks, or potentially liquidity risks.

John Stewart, Co-Head of Operational Risk and Regulatory Compliance Solutions, IHS Markit says, "In my personal opinion, I believe we can say we have ticked the credit risk box, and we may have allayed the regulators' primary concern, but we need to ask if we have stored up challenges that could be the next black swan event for the industry?"

To mitigate these risks, banks and asset managers need to build highly efficient systems and processes that give them a clear picture of exposure to derivatives contracts, and the capacity to match their margin obligations with securities and cash inventory, in order to optimise the allocation of collateral, or transformation of assets where necessary. Most recently, a new technology has been brought to market participants to automate and digitize the legal process of putting in place legal documentation to collect and segregate Initial Margin, called Margin XchangeTM available on IHS Markit's Counterparty Manager.

"In achieving these things we have made significant investments and we are far from being the only bank to have to put these services in place for our clients," says Hélène Virello, Global Head of Collateral and Valuation Services, BNP Paribas. "No one will make millions from the investment; the purpose is to make the market safer. But the problem today is too complex; and so the challenge for the next 10 years is to make these processes more efficient."

Although many firms offer assistance around collateral management, the analysis and management of clauses within the contracts which trigger margin requirements is more challenging. Ideally these will be represented digitally, in order to engage in more automated processing front-to-back.

Making these changes will be imperative for capital market firms who wish to move beyond compliance and towards the competitive advantage that Scott advocates.

"The journey is not over yet, we do have some milestones coming up in 2019 and 2020 for uncleared margin rules," says Clive Ansell, Head of Market Infrastructure and Technology, ISDA. "They are critical, they focus the mind, but unfortunately they don't always focus the mind of everybody. Organisations like ourselves, but also [banks and technology providers] continue to try and encourage people to engage and better understand what they need to do."

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