With margin demands increasing, it is important for the right collateral to be in the right place at the right time, according to the International Swaps and Derivatives Association (ISDA).
Automation of margin calls and collateral settlement is critical to achieving this, said ISDA in its latest white paper titled Mitigating Eligible Collateral Risks: From Documentation to Operations.
“While some headway has been made across the industry, more progress in adopting data standards and collateral management straightthrough processing is necessary,” ISDA said.
Regulatory changes have had a big impact on collateral management, ISDA said, adding that the implementation of margin requirements for non-cleared derivatives, alongside mandatory clearing rules for standardized overthe-counter (OTC) derivatives, means there is more demand than ever for high-quality liquid assets (HQLAs) that can be used to meet initial margin (IM) and variation margin (VM) obligations.
According to the latest ISDA margin survey, IM (initial margin) and VM collected by the largest derivatives firms for non-cleared derivatives totaled $1.4 trillion at the end of 2022 compared to $1.3 trillion the year before.
A further $384.4 billion of IM was posted at major central counterparties (CCPs) by all market participants for cleared interest rate derivatives and single-name and index credit default swaps, up by 18.8% from the end of 2021.
The white paper sets out some of the issues that firms should consider when negotiating credit support annexes (CSAs) with eligible collateral schedules and custodian arrangements and establishing operational structures and workflows, based on input from ISDA members.
ISDA stressed that it is important to understand the pros and cons of each type of collateral, especially as one kind of collateral that is beneficial to a firm’s operations or investment strategy may not be helpful for its counterparty.
For example, based on the margin rules for non-cleared derivatives, corporate bonds and equities may be used for both VM and IM, the white paper said.
According to the latest ISDA margin survey, 6.2% of regulatory VM and 23.1% of regulatory IM received by the 20 largest derivatives dealers was classified as ‘other securities’.
“With cash being required for cleared VM, trends in the industry point to more pension funds and insurance companies using corporate bonds for non-cleared VM. Non-cash VM CSAs are sometimes referred to as ‘dirty CSAs’, while cash-only agreements are known as ‘clean CSAs’,” ISDA said.
ISDA said that firms can strategically plan what collateral they wish to post and receive based on their available inventory, their custodial model and that of their counterparties, operational capabilities (such as valuation and settlement processing) and any capital implications, if applicable.
“Firms should balance these concerns when negotiating new CSAs and eligible collateral schedules or amending existing documents, while also striving to increase levels of automation and adopt data standards to reduce operational friction and risks,” ISDA said.
