Fund Managers: Get Ready for Margin Call Tsunami

Five hundred to one thousand percent.

That’s the eye-popping prediction of the coming increase in margin calls in a new report from US market infrastructure Depository Trust & Clearing Corp. (DTCC), “Trends, Risks and Opportunities in Collateral Management.”

The trigger: new regulations and recommendations requiring far more transactions in far more asset classes to be collateralized. Relying on proprietary emails or faxes to keep track of all the necessary communications won’t cut it so it’s more than likely paper will become obsolete.

Although concise and thorough, the DTCC’s report isn’t telling financial firms anything they don’t already know. But coming from DTCC, which settles and clears millions of trades each day, the clarion call for action is clear. Simply waiting to react until the tsunami of margin calls appears isn’t a good idea — it can be costly and risky.

For every one margin call now, the future could hold five or ten, according to DTCC’s projections. Handling the rush will require a combination of solid systems, operational workflow management and data management, say collateral management experts.

“Financial firms should be revisiting their IT infrastructure as well as their process for addressing margin calls to ensure efficiency,” says Ted Leveroni, executive director of DTCC’s subsidiary Omgeo, a post-trade communications and collateral management software provider. “There is no way to avoid the burgeoning number of margin calls.”

One Call Generates More

Reading a communication on a margin call is just the beginning of what needs to be done. Close on its heels is understanding what the margin call is all about, determining whether or not the request is accurate, finding the collateral, figuring out how much to use, and then sending or receiving it correctly – all of it likely to be handled under time constraints. Forget about weekly or even end-of-day margin calls. Intra-day or real-time is the new mantra.

“What starts off as one step in getting a margin call quickly turns into several and that doesn’t even begin to address what happens when there is a dispute — the counterparties don’t agree on the margin call,” says Mitch Schulman, chief executive of New York-based collateral management software firm IntegriDATA. “It all boils down to keeping track of data– and lots of it.”

As regulators are demanding more securities transactions must be collateralized, it stands to reason margin calls will increase proportionately. Such is particularly the case with swap contracts, many of which have new regulations such as the US Dodd-Frank Wall Street Reform Act in the US and European Market Infrastructure Regulation (EMIR) in Europe that require so-called standardized deals to be processed through central clearinghouses with initial and variation margin. Longer timeframes for repurchase agreements and new recommendations made by a committee of the New York Fed calling for US forward-settling mortgage-agency debt transactions to be collateralized will also add to the collateral management burden. Although the Fed’s operations committee has no legal clout over fund managers, they have little choice but to comply. Otherwise, they risk being shut out of the market by broker-dealers that don’t want to do business with them.

Ignoring a margin call, even accidentally, isn’t an option. There could be hefty financial penalties for a failed transaction depending on the terms of bilateral margin agreements. In the cases of trades cleared through a clearinghouse, clearing brokers in New York tell FinOps they will likely just take the value of the necessary variation margin out of the account of the fund manager. That leaves the fund manager with no say as to whether or not it agreed with the margin call. Of course, should there be a dispute after the fact, the clearing broker have to deal with returning collateral back to the fund manager.

Although both buy- and sell-side firms will likely receive far more margin calls, fund managers could feel sharper pain than their broker-dealer or bank counterparties. The key reason: their lack of experience. “Fund managers could historically rely quite well on spreadsheets, because they were either depending on cash alone to collateralize their transactions or had only a handful of calls each week,” explains Andy Davies, chief executive of London-headquartered collateral management software provider Cloud Margin. “By contrast, it’s likely broker-dealers did have to deal with daily margin calls electronically; therefore, increasing capacity will be a far easier task.”

Adding staff won’t help, say experts. Not only is it likely to be cost-prohibitive, but it’s also an inefficient use of resources. So what’s a fund manager left to do?

Either creating or buying a collateral management platform is an option. However, imagining that it will work in a turnkey fashion is too optimistic. Collateral management platforms need to be configured, not only to the types of deals being tracked, but also to the kind and location of the collateral. The most sophisticated systems will also apply complex algorithmic calculations to determine just how much collateral must be used for each transaction even before a call is made.

All About Data

Critical to the effectiveness of any collateral management system is the accuracy of the data it uses and just how fast it can obtain the data, according to Mahesh Muthu, associate principal of financial services outsourcing specialist eClerx in New York. “Without being fed the necessary information on just what types of collateral they can use and for which types of contracts and which counterparties, the collateral management system doesn’t stand a chance of working correctly,” he says.

Just where can all that information be found? In the case of over-the-counter derivatives, it is in the credit support agreements (CSAs) which typically follow guidelines set by the International Swaps and Derivatives Association (ISDA), the trade group representing the US$650 billion swaps market. Such CSAs contain terms on eligible collateral, how it can be held and used, and the mechanics of margin calculations and posting.

Mining the agreements to find the correct data points can be pretty challenging. A CSA can be decomposed into at least 200 important data points, but collateral management systems have been known to capture far fewer. Making matters worse, they could end up coding the attributes incorrectly, says Muthu. He recommends developing a comprehensive data model — with input from client-onboarding, credit, liquidity and legal teams — to identify and capture the necessary data from CSAs for collateral management and other systems. Also required: a serious data management foundation including data dictionary, data capture rules and data metrics to ensure consistent handling of the data going forward.

Getting the right information on swap transactions into the collateral management system is the tip of the iceberg in ensuring efficient use of collateral. Swap contracts are just one type of asset class requiring collateral in securities transactions. So do securities lending, forward and repurchase agreements. Therefore, any collateral management system will also need to access information on a multitude of transaction types. With this breadth of activity, the data models and process will also become relevant on an enterprisewide basis.

Naturally, aggregating all the data would be a lot easier if there were a single collateral inventory system to store all of the information in a consistent format. And a single centralized collateral management team to boot.

But apparently, collateral management still works in silos. The data on collateral agreements are stored in different systems, the cash or assets which can be used as collateral are stored in multiple platforms, and the calculations on the amount of collateral which must be used to fulfill the margin call are often made by an application attached only to the business unit affected — i.e., exchange-traded derivatives, over-the-counter derivatives, securities lending, and repurchase agreements. It is those business units which must handle any disputes or discrepancies between what the broker-dealer and fund manager think is the correct amount of collateral which must be posted.

Could a single platform and operating unit become a reality for fund managers to address their collateral management procedures more efficiently? Fund managers may have an edge over broker-dealers in seeing this happen. “There is a trend to break down collateral management by departments, but fund managers have far fewer silos than broker-dealers,” notes Leveroni. “Relying on a single collateral management platform could go a long way to solving operational quagmires.”

This utopian idea is probably still way down the road, and the industry isn’t holding its breath in anticipation. Whether to build in-house or support third-party development of such a centralized platform is a multi-million dollar for fund managers. The current vendor offerings for collateral management platforms ranges from the rudimentary low-cost ones providing the mechanical basics to the very complex and expensive ones providing collateral optimization, picking the lowest cost collateral for each transaction, even before it is even executed.

At a bare minimum, the fund managers want to see all of the data about available collateral, and be able to match it up with all the terms of their margin agreements with counterparties. The dream solution would even predict whether the fund manager will get a margin call from a broker-dealer for any collateralized deal and verify that the amount of the margin call is accurate.

Calling All Margins

One aspect of collateral management, which the platforms typically don’t address, is standardizing how margin calls are communicated. The alert of a margin call is typically sent between fund managers and broker-dealers through emails.  Or if they use a collateral system, by the system when it finds the margin threshhold has been reached.

The increasing use of collateral — and automated platforms — has created a problem in electronic messages going from system to system in formats that aren’t understood by the other system. As a result, some firms have opted to rely on MarginSphere, a platform from AcadiaSoft which interprets messages from other systems. About 70 fund managers and fund administrators acting on behalf of fund managers are interacting with 30 broker-dealers on MarginSphere.

“It works as a centralized matching engine of sorts for margin calls and then takes a one-to-many approach in communicating any differences to each other,” explains Chris Walsh, chief operating officer of AcadiaSoft. Because MarginSphere also works in a standardized message format the all users must agree to, the result is clearer and hopefully accurate communication. “What could have been at least eight emails to handle a margin call now turns into just one,” says Walsh.

Automating the collateral management process, regardless of which platform is used or whether it is built or bought, doesn’t come cheap. Five US fund managers contacted by FinOps Report declined to specify just how much their firms were spending, but acknowledged that the tab goes far beyond the cost of implementing an collateral management platform simply because of the additional coding and operational work required in ensuring correct data integration.

So what’s a fund manager to do when dealing with collateral management becomes just too much to handle? Outsourcing the work to a service provider is often an answer of last resort. The largest custodians such as BNY Mellon, State Street, JP Morgan, and Northern Trust, are heavily marketing their full-blown collateral management services with lots of bells and whistles.

“It [automating collateral management] can turn out to be quite expensive; therefore, many fund managers opt to outsource the work to external parties, such as administrators or custodians, who can afford to invest in sophisticated platforms and spread the cost across many clients,” says Muthu.

Still, outsourcing may be just for the brave of heart. “Not all fund managers want to give their custodians or administrators access to all of their data and there are concerns about whether the custodian can really live up to the task for all asset classes,” says one operations executive at an East Coast-based fund management shop which has opted to keep collateral management in house. “Outsourcing does require oversight so it might not be all that cost-effective depending on the types of agreements involved, the volume of transactions, and the number of expected margin calls.”

 

Related articles:

Margin Standards for TBAs May Edge Funds Out of the Market, January 21, 2014

EMIR: One Little Number Can Make or Break Reporting, January 28, 2014