2: Posting Collateral
One of the most disruptive changes on the buy side under the new derivatives rules will be the need to manage margin calls from the clearinghouses on cleared swaps. "Some clients are going from never having to post initial margin to now always posting margin," comments Morgan Stanley's Swankoski. When clearing becomes mandatory, "All clients, big or small, are going to have to post initial margin on their cleared transactions."
Adds Morgan Stanley's Arnason, "As clients move from a non-cleared world to a cleared world, many will require adjustments to their operating models in meeting margin requirements. It's a safer system, but for many clients, increased collateral requirements make it a more expensive system."
Morgan Stanley built OTC clearing functionality into Matrix, the firm's client portal. It offers a real-time dashboard showing positions for cleared as well as bilateral transactions, according to Arnason. One of the value-add tools that the company provides through Matrix, he relates, is "What If" predictions of initial margin requirements.
"By effectively replicating pricing and risk management algorithms used by the central clearinghouses, we predict what the margin call will be on their portfolio tomorrow," Arnason explains. This is an important indication of how much collateral the client requires to meet that margin call, he says, adding that clients could even use the tool to backload trade scenarios to reduce any initial margin.
Adding to the buy side's burden of posting margin, the clearinghouses require a strict pool of assets to be used as collateral, which many buy-side firms don't have, says Philip Forkan, director, Sapient Global Markets. "At the moment, the clearinghouse is only taking a small amount of high-level collateral," he explains. "Obviously the clearinghouse is there to reduce clearing risk, so it's very particular as to what assets it's going to take, but it may not correlate to what the asset managers have [in their portfolios]. This is a concern to the asset managers since they need to sell out some of their high-yielding assets and transform them into assets that are low-yielding but high-quality assets."
To help buy-side firms complete this process, the clearing brokers are looking to provide collateral transformation services, according to Forkan. "They're now building in services to ensure that organizations that post one type of asset can convert it into another type of asset," he says. "That is a cost of clearing that the asset management community is going to have to bare. Given the huge investment that the banks have made in technology and infrastructure, they are keen to offer services that generate profit — it's a large opportunity for the global banks to grab market share among the asset managers that need services."
3: Gaining an Accurate Risk Picture
Another big challenge for buy-side firms will be managing their existing bilateral OTC derivatives business alongside cleared swaps to gain a holistic picture of counterparty risk. Since not all trades will be required to be cleared, buy-side firms will have both a bilateral book of trades that they are still managing as well as daily collateral calls for the cleared book of swaps, says Omgeo's Leveroni. "You will end up with a mixed clearing environment and operational complexity that you didn't have before," he cautions.
In fact, Leveroni contends, the Dodd-Frank requirements for central clearing of some swaps actually have introduced direct risk into the swaps market. "There is a bifurcated operational environment that participants have now," he explains. "You don't want to take a separate system and manage your movements for your cleared business."
Leveroni suggests that firms expand their existing OTC bilateral systems for collateral management to handle both the bilateral and cleared flows, which would allow them to see in one system their counterparty risk -- whether it is on cleared or non-cleared derivatives. Omgeo is in the process of linking FCMs to its collateral management system so that firms can manage their collateral on one system, according to Leveroni.
"The buy side is going to struggle with having enough collateral to post for the book of business," Leveroni says. "This is worrying a lot of people. You want to make sure you manage that collateral right, so you only send cash to the cleared call and you send the corporate bond to your bilateral call. You have to be smart in the collateral you send to each call. Those are the real risks to the buy side."