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As Central Clearing is more and more widely adopted around the globe, collateral, especially highly liquid collateral, is in high demand. Compared with bilateral transactions, central counterparties (CCPs) not only require the clearing members to post collateral for Variation Margin (VM) but also other margins such as Initial Margin (IM) and Delivery Margin (DM) , and contribution to Default Funds (DF). The latter, in particular IM, can be substantially higher than VM, depending on the type of transactions. It is estimated that USD $2trillion collateral will be held at CCPs.
As high quality collateral becomes scarcer in the market, it is imperative for banks to effectively manage their collateral. An effective collateral management not only helps the banks meet the collateral requirements in a timely fashion, but it can also create opportunities to optimize their use of collateral, which can lead to benefits such as lower cost of funding, more favourable regulatory capital treatment, higher market liquidity, and so on.
To enable an effective collateral management, the following is required:
However, to have effective collateral management is easier said than done. Below is an example that illustrates the challenges faced by the banks:
Illustration 1: Example of a Bank/dealer's collateral requirements
In this example, we assume the Bank is connected to several CCPs while keeping the bilateral trading as well . The Bank not only clears its own trades through CCPs but also acts as clearing broker to clear clients’ trades through CCP.
As illustrated, given the number of CCPs and bilateral counterparties, the different criteria for the collateral types and haircuts, different time tables, and different collateral posting processes, it will be challenging for the Bank to have a clear and comprehensive view of collateral inventory and movement, as well as a streamlined operational process. This example only illustrated margin collateral management. Trading businesses such as Repo and Sec Lending, which involve trading based on underlying collateral, will inevitably add to the complexity.
Given the complexities and challenges, the following areas can be explored by banks:
As the banks move towards more efficient collateral management, CCPs need to keep pace with the changes. For example, some CCPs still use a very manual process in managing margins calls and collaterals, instead of an automated system and a customer friendly interface. After all, CCPs are in place to protect the financial market from systemic risks and address the market liquidity issues in distressed market. Without carefully managing the collaterals going forward, the shortage of high quality collateral may pose a risk to the market itself.
Is your organization facing challenges in collateral management given required central clearing? Join the discussion
This content is provided by an external author without editing by Finextra. It expresses the views and opinions of the author.
Neil O'Connor CTO, Experian Consumer Services at Experian
13 June
David Weinstein Co-founder and CEO at KayOS
Ruchi Rathor Founder at Payomatix Technologies
11 June
Shane Rodgers CEO at PDX Global
10 June
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