September 25, 2012

While the $270 billion of annual revenue that over-the-counter (OTC) securities and derivatives dealers collect from trading will likely fall by at least 20% once mandatory clearing becomes effective, new revenues driven by collateral optimization services for non-cleared swaps are likely to backfill that lost revenue.

Collateral optimization will allow dealers supervised by U.S. banking regulators -- which we'll call "bank dealers" -- to operate under specific margin collection rules to collateralize non-cleared swaps, including segregation, calculation, and netting. This is known as the joint margin proposal, which is margin collection-based. That is, it focuses on the margin collection responsibilities of bank dealers rather than the margin posting obligations of their counterparties. This is analogous to the authority, power and discretion provided to designated clearing organizations (DCOs) under the cleared swap rules.

Swaps that are not novated, or subject to the rules of a DCO, are generally referred to as "non-cleared." Unlike cleared swaps where margin rules are governed by DCOs, non-cleared swaps, which comprise the majority of traded swaps today, will likely have their margin rules controlled by bank dealers through an interconnected series of straight-through automation processes.

Bank dealers, which are subject to heightened and enhanced oversight through prudential supervision, have the greatest potential upside in the development of this market. They are uniquely constrained by increased capital maintenance and exposure requirements prescribed by Basel III, and concurrently are best positioned by their interconnectedness, affiliations, and technological capabilities to build out compelling value propositions around their collateral optimization capabilities. In order to seize the potential revenues under the joint margin proposal, bank dealers will likely utilize a margin calculation and analysis engine that can model multiple scenarios of allocation of collateral between margin requirements across multiple business activities and trading books.

Collateral optimization services are positioned to serve as both key elements of a compliance mechanism purportedly satisfying the business conduct standards under Dodd-Frank, as well as a means to facilitate the non-cleared swaps marketplace. This is possible because the joint margin proposal states that initial margin may be calculated on a portfolio or netted basis rather than the gross collection requirement for cleared swaps. As a result, collateral optimization benefits can be recognized within and between commodity, credit, equity, foreign exchange and interest rate-based swaps – including economically equivalent swaps where an exemption from clearing may be asserted.

To be truly strategic, a dealer's collateral optimization solution requires a straight-through approach linking pre-trade analysis, margin monitoring, collateral valuation and transformation, up to post-trade processing; all powered by sophisticated algorithmic models. For example, with these capabilities, a bank dealer can offer a bona fide end=user optimization services analyzing its clearing options. This is accomplished by conducting a number of pre-trade "what-if" scenarios with different margin requirements, counterparty specific CSAs, netting benefits and possible capital charges to derive a total cost of trade that can be used in combination with its present value to recommend which counterparties would minimize collateral costs for a given profitability target. An example of the added value of this analysis would be whether to invoke an end-user exception, or not, and what if any, cost efficiencies exist. More value can be offered to the end-user by pushing a selected what-if scenario straight-through to the dealer's execution services or if margin calculation and collateral optimization services are able to continuously rebalance the allocation of collateral. This would be an effective strategic collateral allocation service that could lead bank-dealers to attract new customers and discover new revenue.

Bank dealers that use a collateral optimization solution that does not adequately support a compliance perspective, scenario analysis, re-hypothecation calibration, investment foresight, asset weighting, or risk analysis in an integrated manner will likely miss this business opportunity.

Alternatively, bank dealers that do not choose to invest in a model-based margin calculation and collateral optimization solution must instead rely on a table grid approach that conservatively sets margin requirements as a percentage of the notional amount of the swap. For these dealers the recoupment of lost transactional revenue is unlikely, as customers are likely to look for dealers where their collateral will be used to maximize their market benefits.

- Daniel Parker is VP, SunGard's capital markets business