The Unknown Collateral Impact of Regulation

New global regulations are changing the way that financial services institutions need to run their collateral management operations.  Basel III, Dodd-Frank, and EMIR are all adding complexity to collateral requirements for cleared and uncleared swaps and have made the use of spreadsheets and simple databases inadequate and risky.

The question is: To what extent will these regulations increase collateral requirements for FSIs?

The Bank of England directed a study in 2012 that estimated new regulatory requirements could increase new collateral demands as high as $800 billion. The increase in collateral requirements is fueled by regulations that mandate central clearing for over-the-counter (OTC) derivatives as well as new requirements for non-cleared OTC derivatives trades. Clearinghouses (CCPs) have imposed stringent initial margin requirements which will likely increase the demand for high-quality collateral. Clearing houses have allowed “netting” – eliminating trades of the same product type that cancel each other out – to reduce the amount of margin and collateral on each trade. Netting has mitigated some of the risk, but its advantages cannot occur across CCPs. Many believe that a “collateral crunch” is coming which could bring unknown consequences to the financial markets.

What’s clear is the demand for collateral held against OTC trades is projected to rise – along with the operational intricacy of moving and segregating margin. OTC trading volume will likely decrease as demand for collateral increases and costs rise. Collateral issues may even push traders away from the OTC swaps market to the futures market which has lower capital requirements – which are often called “futurization.”

Collateral optimization will be a focus for buy-and-sell side firms even with the impact on trading volumes. Institutions will be forced to streamline collateral management and optimization as the cost of collateral increases, and those who do this well across all derivatives trading will see a significant competitive advantage.

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