Institutional investors face pressing challenges in sourcing and managing collateral for OTC derivatives clearing, and must confront the reality that the issue is one they need to address sooner rather than later. But what steps can institutional investors take to address these collateral management challenges?

One approach is to reduce OTC derivatives activity. Institutions could even go so far as to simply cease using OTC derivatives, whether cleared or on a bilateral basis. However, the widespread use of these instruments demonstrates their usefulness in implementing investment strategies and hedges, and they are critical to many investment products, such as Liability Driven Investment (LDI) mandates or synthetic Exchange Traded Funds (ETFs).

Banks, facing the same challenges, are investing in collateral optimisation infrastructure that seeks to maximise the efficiency with which assets are sourced from across the firm to meet collateral obligations. Unfortunately, the assets available to institutional investors are fragmented across portfolios, and cannot readily be pooled. This is not to say that there are no options available to them in addressing the collateral management challenge. What is needed is a more proactive approach to sourcing eligible assets.

We suggest that institutional investors that wish to remain active users of OTC derivatives consider the following:

1. Review OTC derivatives strategies to establish what cleared contracts will be used.

Determine which Central Counter Parties (CCPs) need to be accessible and clarify which clearing broker they should be using. The changes happening in the market mean all derivatives activity should be considered as some CCPs are expected to start offering netting across the market in the near future.

2. Model the initial margin requirements of your OTC derivatives portfolio.

Seek support from a clearing member or a CCP to help with the modelling.

3.Identify all incremental costs under the new rules.

Recent regulations have forced much change on the industry, and portfolio managers must ensure that they are aware of what their costs will be in the new trading environment.

4. Does your investment process need strategic or tactical alterations?

Reviewing investment strategies could open up ways of reducing the collateral burden and lessen the impact of costs.

5. Are you using the most cost effective services?

In some cases, using an outsourced collateral management service provider or moving towards a tri-party collateral management service could bring real efficiencies to collateralisation by raising CCP-eligible collateral through other markets such as repo or securities lending.

Institutional investors need to be actively engaging with clearing brokers, tri-party agents and custodians to consider all viable sources of collateral. They should consider changes to strategy, process, relationships and documentation in order to develop robust solutions. The alternative, unfortunately, is to step back from the OTC derivatives market.