Institutions ranging from asset managers to hedge funds and insurance companies became suddenly more aware of the need to manage the risk of counterparty default.
Frequent users of derivative products, such as asset managers, realised that these instruments – which are very cost effective for hedging risk in areas such as currency, interest rate or credit event – are only going to be valuable if the counterparty they have credit exposure to is able to fulfill their obligations.
“Extreme events such as the Lehman collapse woke institutional investors up and made them realise the importance of counterparty risk,” says David Suetens, chief risk officer at ING Investment Management. “Most people these days have implemented quite robust collateral programmes to protect their clients’ assets.”
REAL TIME VALUATION
Collateral management involves tracking and valuing collateral throughout the life of a trade and making margin calls. If the mark-to-market change of a particular deal or net portfolio position has moved by at least the minimum amount, collateral is then posted or received by the counterparty.
Traditionally, valuation has been done on an end of day basis, but is now moving toward intraday and real time valuation, where possible.
Collateral agreements are often bilateral: the fund manager will receive collateral from the counterparty, such as the swap dealer it does business with, when it is “in the money”, but it will need to give collateral when it is it “out of the money”.
Whether it is in or out of the money, depends on the value of the derivative. The day the fund manager enters into a derivative contract the market value is zero. The value of the derivative fluctuates, depending on the yield curve.
“Normally you agree a relatively low threshold, which means that as soon as you are out of the money, or in the money, you have agreed with your counterparty to wire collateral one way or the other way,” says Mr Suetens.
Asset managers tend to be very conservative when it comes to the form of collateral they want, explains Mr Suetens. Mostly they use cash, as it is very easy to liquidate should the counterparty default. Some managers may accept government bonds, but never equities or corporate bonds, he says.
Depending on the credit rating of the collateral, a higher haircut may be applied. This means that an extra additional margin of collateral of 2 to 5 per cent is required for government bonds compared to cash. The longer the maturity of the ‘govies’, the higher the additional margin.
Collateral management is a risk mitigation technique where counterparty risk is replaced by legal and operational risk, explains Mr Suetens. There is often a timing gap between the moment the value of the derivatives is calculated and the time the margin call is made and received. If the counterparty defaults, the yield curve changes dramatically, and a small part of the exposure may be under-or over- collateralised.
Also, it is crucial to assess the value of the derivatives correctly to be able to make the right margin call, but at times, it is quite difficult to price correctly complex OTC (over-the-counter) derivatives. As to the legal risk, it is paramount that the legal agreement is enforceable by the liquidator.
As in any business decision, the decision to outsource the collateral management process to a third-party depends on a number of variables. “ING IM is a sizeable house, so we can afford to have our internal collateral team and dedicated legal team,” says Mr Suetens.
“A small asset manager may consider outsourcing to a third-party. But even when you outsource, you need to demonstrate to your clients and to the regulator you are still in control and are able to monitor the partner you outsource to,” he adds.
UPCOMING REGULATION
Regulation is likely to affect the business decision on whether to outsource or to build internal capabilities. The upcoming central clearing system for OTC derivatives is seeking to address the risks in over the counter trading by imposing mandatory central clearing for standard derivatives. These deals are negotiated and executed on a bilateral basis and therefore increase the risks on individual counterparties to a trade. Central clearing involves a central counterparty (CCP), which will be highly regulated and supervised, sitting between buyers and sellers.
The CCP absorbs the risks facing individual firms and acts as the ‘circuit-breaker’ in the event of market stress. This will improve the transparency and the standardisation throughout the trade and mitigate risk.
