Following a series of market stress events, reducing manual intervention and creating greater efficiencies in collateral management has become increasingly necessary. Data standardisation and automation of key processes offer a way forward, says Amy Caruso, head of collateral initiatives at ISDA
In financial markets, meaningful change is usually achieved in incremental steps. It might start with a new regulatory requirement or a switch in market convention, but further work is often needed, sometimes over a period of several years, to fully realise certain efficiencies, cost savings and reductions in risk.
Collateral management is a case in point. Following the global financial crisis in 2008, market participants were required to exchange collateral on their cleared and non-cleared over-the-counter (OTC) derivatives trades, which contributed to an overall reduction in systemic risk. But as firms focused on meeting the regulatory requirements, they often lacked the bandwidth to pursue standardisation and automation of collateral management processes, continuing to rely heavily on manual intervention.
In recent years, a series of market shocks has shone a light on the implications of a lack of end-to-end automation, generating momentum to digitise documentation, automate workflows and standardise data across the different phases of collateral management. With more collateral being posted and collected each year, it is critical these processes are as efficient as possible to avoid collateral management becoming a source of risk in itself during periods of market stress.
Risk mitigant
During the 15 years that have passed since the Financial Crisis, increased clearing of over-the-counter (OTC) derivatives and margin requirements for non-cleared derivatives have led to a huge increase in the volume of collateral in the system. Central counterparties require margin to be posted against cleared trades and the amount required may increase during periods of volatility, while the number of firms required to post margin on non-cleared trades has grown with successive phases of implementation of initial margin (IM) regulations since 2016.
IM and variation margin (VM) collected by leading derivatives market participants, subject to the margin rules for non-cleared derivatives, totalled US$1.4 trillion at year-end 2022, compared to US$1.3 trillion at the end of 2021, according to an International Swaps and Derivatives Association (ISDA) survey. Based on responses from 32 firms, which comprise most of the entities included in the first three phases of implementation, US$325.7 billion of IM was collected by year-end 2022. This represents a 7 per cent increase on the US$304.1 billion of IM collected by the same group of firms at the end of 2021.
In September 2022, the sixth implementation phase of IM requirements brought hundreds of smaller banks and buy-side entities into the scope of the rules. Going forward, any legal entity with an aggregate average notional amount of non-cleared derivatives of more than €8 billion must now comply with the IM requirements. As more entities cross that threshold in the future, this will lead to the exchange of ever larger amounts of collateral.
The rising volume of collateral in the system certainly helps to insulate market participants during periods of market stress, but it has become clear that the end-to-end framework for delivering collateral is in desperate need of improvement. Key processes such as margin calls, settlement, substitutions and recalls are not currently automated, while a lack of interoperability and real-time data transfer between OTC and exchange-traded derivatives, repo and securities lending activities has become a source of operational risk.
ISDA has been working to promote automation, reduce risk and bring greater efficiencies to collateral management. In 2017, we published a blueprint for the optimal future state of collateral processing and we followed up with four collateral management transformation toolkits in 2020. These kits provide resources to help firms identify opportunities to improve collateral management, including digitising ISDA documentation, automating margin calls and collateral settlement, and streamlining portfolio reconciliation and dispute management.
Addressing fragilities
A series of unconnected market shocks during the past three years has highlighted the fragilities in collateral management and underscored the urgent need for greater efficiency and automation.
In March 2020, the onset of the COVID-19 pandemic triggered the ‘dash for cash’ in financial markets, with widespread selling of assets and heightened volatility. In early 2022, Russia’s invasion of Ukraine led to volatility in energy markets, while a UK government fiscal announcement in September 2022 prompted a sudden spike in gilt yields. In each of these cases, the external shock was unique, but it led to a drain on liquidity as assets were sold off, with central banks intervening on several occasions to stem the disruption in key markets.
A common thread running through each episode was a huge increase in margin calls driven by a spike in volatility, leading firms to sell assets or tap repo markets to generate cash to post as collateral, putting extra strain on liquidity. In the UK, some liability-driven investment (LDI) funds had specified in their trade documentation that only cash could be posted as collateral. During the gilt crisis, this meant they had to sell long-dated gilts to meet their obligations, contributing to further margin calls and forced gilt sales, which ultimately required the Bank of England to step in with a large round of gilt purchases.
For many market participants, these unconnected shocks have shown that inefficiencies in the management of collateral are not just an operational strain during normal market conditions, but can become a major source of risk when volatility strikes. With mounting margin calls and settlement volumes, as well as operational and data challenges, the continuing reliance on manual processing meant firms were unable to meet their obligations in a timely manner, or had to find additional resources to alleviate the strain.
Even before the gilt market crisis, international policymakers had been exploring areas where margining practices could be improved. In September 2022, the Basel Committee on Banking Supervision, the Committee on Payments and Market Infrastructures and the International Organization of Securities Commissions published a review that identified six areas for further work. These include enhancing the liquidity readiness of market participants, increasing transparency and streamlining VM processes in cleared and non-cleared markets.
As policymakers continue to work on those six key fields, ISDA is moving at pace to build on our efforts to transform collateral management. In addition to the toolkits that have proved to be a valuable resource for our members, we have worked with the industry to publish suggested operational practices that cover a range of processes, including onboarding custodians and counterparties, margin call affirmations and confirmations, settlement and substitutions, reporting, and portfolio reconciliation and dispute resolutions.
As we seek to consign manual processing and operational inefficiency to the past, we want to work with all market participants, including buy- and sell-side firms, technology vendors, infrastructure providers and custodians to promote greater standardisation and automation.
For that, we are leveraging the Common Domain Model (CDM), a free-to-use data standard for financial products, trades and lifecycle events that is available as code in multiple languages. The CDM has already been used to develop standard digital representations of collateral specifications and to support operational provisions of ISDA’s most widely used credit support documentation. ISDA is now working on other use cases with the aim of improving interoperability and streamlining the processing of collateral.
An efficient collateral management process starts with document negotiation and execution. Firms can use the ISDA Create online documentation negotiation platform, which brings efficiency and transparency to the process of developing and executing key documents. Crucially, the CDM allows legal data captured during the negotiation process to be made available as a standardised digital output. This can reduce manual onboarding to collateral management systems, thereby addressing some of the root causes of disputes and post-trade operational discrepancies.
As collateral management spans multiple markets, including exchange-traded derivatives, OTC derivatives, repo and securities lending, it is critical that efforts to bring greater efficiency extend to the full ecosystem.
To that end, ISDA has worked with the International Capital Market Association (ICMA) and the International Securities Lending Association (ISLA) to identify common challenges and leverage the CDM to promote data standardisation and automation. Together with ICMA and ISLA, we have developed collateral representations across products, which will reduce onboarding time and improve interoperability and collateral optimisation processes.
Following the experience of recent market stress events, which highlighted the need for collateral management transformation, we are now on the cusp of a new era. Building on the successful implementation of regulatory IM requirements, the constructive and collaborative work that is now being undertaken across the industry will lead to a disciplined framework for collateral management that is more efficient and resilient than ever.
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