Over-the-counter derivatives dealers must do a better job of managing collateral requirements and, in some cases, finding vendors to help them. This, according to a new report, will compel firms “to actively manage and finance collateral on a more integrated and timely basis.”
That’s the conclusion of a new report by industry consultant Woodbine Associates, “Collateral Management and Vendor Systems: Requirements and Solutions in the New Regulatory Framework.” It says these issues will critically affect trading, risk and liquidity management.
The new framework created by Title VII of the Dodd-Frank Act will require most firms trading these contracts to centrally clear them. That means using a public marketplace, such as a clearinghouse or a central counterparty (CCP), instead of the bilateral, dealer-to-dealer model, which will be allowed but more heavily regulated.
But whether firms continue to operate on a dealer-to-dealer basis or centrally clear OTC derivatives contracts, they must be ready for new operational challenges, according to the report.
“Participants will be required to post greater amounts of cash and securities to CCPs under more restrictive terms, and on a more frequent basis to margin OTC transactions,” the report said. “Industry demand for high-quality assets to be used for initial margin and liquidity management will create more variable financing rates in the repo and securities lending market.” And that, the report said, will require efficient inventory management essential or costs will become huge.
For those who continue the bilateral method, Woodbine Associates said, firms will need to operate under a more difficult environment.
Collateralization and initial margin requirements will affect a much larger universe of transactions, will be subject to more stringent constraints and will be done more frequently, the report said. “This will serve to increase the operational complexity of collateral processing and make efficient allocation of pledged cash and securities more critical to firms seeking to minimize costs.”
How can firms trading OTC derivatives cope with these new rules? The report said firms will often need support to bring their systems up to Dodd-Frank standards. However, it added, vendor solutions can carry “considerable risk.”
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