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Clearing and Collateral: Distant cousins or close relatives?

The Dodd-Frank and EMIR reforms are having a major impact in the way market participants engage with one another. The mandatory central clearing of swaps is giving rise to a new market infrastructure that introduces more roles and processes, all requiring computer systems to make them work efficiently – Swaps Execution Facilities (SEFs), Organised Trading Facilities (OTFs), Multilateral Trading Facilities (MTFs), Electronic Communication Networks (ECNs), Exchanges, Application Service Providers (ASPs), Swaps Document Repositories (SDRs), Central Counterparties (CCPs), Direct Clearing Organisations (DCOs), Direct Clearing Members (DCMs),  Swap Clearing Members (SCMs), Futures Clearing Members (FCMs), Tri-party, Quad-party, Custodians, Banks… and there are Clients in the mix somewhere as well. Also, new rules will require clearing houses to accept and register trades within a short timeframe, measured not in minutes or hours but in seconds.

Risk management has always been a core strength of any clearing house, with risk systems integrated into the trade acceptance process. Collateral management was much more of a back office process somewhat separated from the real-time world of trade registration. But this is changing – the collateral process needs to get much closer to margin calculation and clearing.

In order to accept a trade, the clearing system needs to calculate the IM, VM, overall margin requirement and whether there is a need for a margin call. To do this, the risk systems will need to become more sophisticated – pulling detailed collateral information into calculations. Ideally the status and value of the client’s collateral is checked in real-time to ensure that there are sufficient assets deposited to cover the trade. So (ideally) the trade registration and risk management systems have a real-time link to the collateral management systems, which in turn have a real-time link to the settlement state of cash and securities that have been deposited by the client. This means real-time links to all of the banks, depositories, custodians, tri-party agents in order to achieve this. It’s technically possible, but it’s likely to require significant changes – to systems and business procedures.

It follows then, that the ability of the clearing houses to validate and register trades within a one minute target will be difficult to achieve. Complying with such demands is likely to require deeper integration of risk and operations functions and the implementation of expensive technology solutions to crunch the data. It is likely that interim solutions will be introduced, such as providing intra-day credit-lines that are drawn down by new trades and topped up periodically through margin calls and “batch updates” from settlements. Either way, a lot more collateral will need to be processed, stretching people and systems until long-term solutions are introduced.

Research has shown that many sell-side and buy-side firms are inadequately prepared for the coming changes. Although the big banks and other large sell-side firms have invested heavily in readying themselves for the changes, smaller firms with fewer resources are taking far longer to prepare themselves for the coming storm. A survey taken at a recent Fleming Europe collateral conference suggested around 60% of firms are “struggling” to afford the changes necessary.


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