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11 June 2013

Hedgeweek: Negotiating the collateral management paradigm shift under Dodd-Frank & EMIR


Phase one of Dodd-Frank commenced in March this year, requiring swap dealers and major swap participants to clear their OTC derivative contracts through central counterparties. With phase two commencing in June, buy-side firms in the US are now fully engaged in getting operationally ready.

The shift towards OTC clearing is a huge collective undertaking for clearing houses, clearing firms and buy-side clients. The use of a CCP is a mutualised risk model that shifts the market away from what were exclusively bilateral arrangements – under master agreement and credit support annex (CSA) - to one where both the FCM (as a clearing house member) and the client will be required to post margin into the CCP. It is a radical departure. Many are still coming to terms with the concept that all derivative contracts such as IRS and CDS (and not only interdealer ones) will now have to be cleared with initial margins and variation margins based on the mark-to-market’s daily fluctuations, just like exchange-traded derivatives.

One of the biggest concerns that hedge fund managers have relates to collateral management. Every day, all CCPs will demand (or return) “eligible” collateral, mainly cash and highly rated government bonds, thus generating more transfers, in both the number and value of movements, compared to the bilateral ISDA CSAs.

Even though in Europe, the mandate to clear OTC derivatives under EMIR is not expected to be implemented until 2014, BNP Paribas Securities Services has already noticed a sharp spike in collateral volumes. “Some of our clients are having to clear their derivative contracts already, due to the fact that they trade with US counterparties and fall under Dodd Frank regulation. As they face these initial margining requirements, we are seeing an increase in the amount of collateral needed by their clearing brokers”, says David Beatrix, senior business developer for OTC derivatives at BNP Paribas Securities Services.

As a global custodian to hedge fund and other asset managers, BNP Paribas Securities Services plays a vital role. This entails providing the right solutions for managers’ collateral management needs, in terms of accessing, protecting, managing and ultimately using their assets to meet collateral demands under new market regulation.

Collateral Access spans collateral management, sourcing, optimisation and protection. Beatrix notes that one of the drawbacks of the OTC regulation is that it will generate complexity and fragmentation of processes between cleared derivatives, under potentially multiple clearing agreements, and non-clearable ones remaining under the scope of bilateral agreements with each counterparty. Moreover the bilateral CSA allows managers to net their full exposure to a given counterparty in a single currency, with thresholds and minimum transfer amounts. “However, in the new OTC clearing environment, managers don’t have this flexibility. They have to pay variation margins in different currencies. This is why the volumes of collateral being moved are exploding in number. Managers will have to closely monitor what will become a more complex collateral management process.”

The impacts of regulations on systems and operations are subsequent and the reporting of collateral to Trade Repositories under EMIR also needs to be considered.

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