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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."