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 Jack Dixon
Director, Derivatives
Counterparty risk management has become a very important term over the past 18 months and there are many things to address with the processes necessary to support this area. To date, there has been an imbalance in progress of counterparty risk management with most of it driven by the dealer side. While the buy-side is beginning to make investments in counterparty risk processes like collateral management and reconciliation, many of the processes and automation that have been put in place to support the dealer-to-dealer market will not meet the broad needs of the buy-side community.
For decades, the major Wall Street broker/dealers have invested in counterparty risk management and over the past several years have focused specifically on counterparty risk in the OTC derivatives space. In letters to the Federal Reserve and other regulators, the dealers have had to make commitments on confirmation and reconciliation rates to prevent having regulations forced upon them. The dealers always start out with commitments between themselves because they know that by focusing on the derivatives trades amongst the top 16 dealers they can automate 60% of the trade volume in the marketplace. To make further progress, dealers eventually have to turn to there buy-side clients who number in the thousands and have a very wide range of automation capabilities.
The buy-side, on the other hand, has underplayed the importance of managing counterparty risk, as the majority of buy-side firms don’t have a collateral management process established. There are numerous examples of buy-side firms, particularly hedge funds, who don’t perform their own collateral calculations. They instead receive a margin call from their dealers and trust it’s accurate. Others attempt to perform some basic calculations on a less frequent basis (weekly or monthly) and when they get a margin call they “eye-ball” it to see if it seems reasonable. Some firms, particularly large asset managers, have made some investment in collateral systems and processes. While the majority of the buy-side, citing budget limitations or other priorities, has yet to invest in collateral management processes, things are changing on account of the demise of Lehman Brothers, which has taught a few valuable lessons:
No counterparty is safe – The buy-side underplayed the importance of counterparty risk management because most of their counterparties were the biggest dealers on the street who no one envisioned could fail. That assumption has been destroyed.
Exposure is broader than you think –Counterparty exposure can be much broader than OTC derivatives when considering all the products being traded like FX, repurchase agreements and exchange-based derivatives.
Realization of counterparty risk can happen quickly – The risk profile of a counterparty can change within a few days. With both Lehman and Bear Stearns, rumors about their stability circulated for a couple of weeks. On a Thursday evening greater transparency was provided about their tenuous situations and by the following Monday they were either acquired (Bear) or bankrupt (Lehman). Firms must be able to respond to changing credit worthiness and quickly move their collateral assets accordingly. Just ask the hedge funds who are still trying to get their collateral back from Lehman.
For the industry to make progress, the buy-side needs to invest in collateral management capabilities or outsource the process. Effective counterparty risk management begins with being diligent in knowing the counterparty and properly evaluating their credit worthiness. There also must be efficient operational mechanisms in place to mitigate the extent of exposure. For the industry to become truly efficient with collateral management processes, 3 key building blocks are required: individual firm responsibility, counterparty transparency and efficient transactions.
Taking ownership of internal collateral management processes means different things for each individual firm. The sell-side has made large investments in collateral management already, so their challenge lies in fully understanding their exposure to an individual client across all business units and positions. A dealer might pull in over two million records from about a dozen systems into its collateral system to try to achieve this complete view per client.
Many on the buy-side, on the other hand, need to establish a collateral process to calculate their counterparty exposures and to know when they are under/over collateralized on frequent (preferably daily) basis. For the industry to make progress, the buy-side needs to invest in collateral management capabilities, or outsource it to someone who can. In the past, purchasing a collateral management system was cost prohibitive particularly for smaller firms; however, more options are becoming available. New vendors are providing solutions and custodians, IM outsourcers and hedge fund administrators are bringing more services to market.
Critical to effective counterparty risk management is ensuring that counterparties have consistent views of a portfolio and its positions through an established reconciliation process. There has been much effort made in this area amongst the dealers who are on track with their commitment to the Fed to reconcile weekly. The current commitments are only for OTC derivative trades with established CSA agreements. Over time the industry should expect the regulators to broaden their definition of exposure and to expect these commitments to extend to the buy-side.
Reconciling with the buy-side can be a little more complicated not only because they want to reconcile their entire portfolio exposure, but they also come with service providers who play different roles. For instance, funds managed by traditional asset managers have a custodian who also tracks these derivative positions and have a responsibility to value the portfolio and report it to the end client. Investment managers want to be in sync with not only their dealers but their custodians as well. SIFMA currently has a 3-way reconciliation working group underway to establish guidelines for this workflow.
The 3-way reconciliation working group is looking beyond reconciling derivative positions and believes that reconciling collateral positions is also important. This makes sense in the context of collateral management and margin call disputes. Reconciling derivative positions and their values only addresses part of the equation. The collateral requirements driven from those positions are important, as is the need to then reconcile with your counterparty on what collateral has been posted, the value of that collateral and where it is being held. Only with this complete set of information can you effectively investigate margin call disputes and be confident you are effectively managing your counterparty risk.
As the community makes progress on the first two building blocks it will eventually need to focus on an efficient margin call and collateral movement process. Currently, margin calls are communicated via phone, fax or at the more efficient end, the emailing of spreadsheets or PDF files. There is no automated process between firms’ collateral management systems. In an ideal situation, such automation would allow a margin call to be sent to a counterparty as soon as the exposure is calculated which in turn could be accepted instantly by the counterparty (if within a certain tolerance to the counterparty’s calculations). The counterparty could then communicate the types of assets to be pledged as collateral and send instructions for the movement of the collateral.
While this may seem simple enough, the industry has not made much progress in this area despite SWIFT having messages defined for this very purpose for over ten years. However, having established messages is useless if no one can implement them. Processing SWIFT messages assumes all firms involved have also made the investment in collateral management systems, which is clearly not the case. Second, a message set isn’t enough to handle the conversations between counterparties for what is an immature process. Things get more difficult when the counterparty wants to dispute the margin call or has incorrect instructions for moving collateral assets. Any process will have to compliment reconciliation which is the foundation for dispute resolution. Third, the overall workflow involves more than two parties communicating between each other. For the buy-side this process can involve IM outsourcers, hedge fund administrators, custodians or prime brokers. This can result in multiple workflow configurations for the margin call process.
Equally important is that not everyone is planning to implement SWIFT. While it is popular with banks for sending/receiving payment and collateral movement instructions, not everyone has the scale to justify a SWIFT implementation, even among the majority of the top 25 investment managers. For the OTC derivative space, many firms are implementing FpML because it is the most robust standard to describe derivative products. Yet, for exchange-traded derivatives the industry has put its support around FIX protocol and collateral management messages have been incorporated in the 5.0 version. To truly make progress, the industry needs a universal service that can mediate the varying workflows and support the varying interfaces and standards that will evolve.
Dealing with counterparties that are operationally proficient is extremely important in reducing counterparty risk and mitigating the time that elapses between realization of an exposure and the collection of collateral. With efficiency established, firms can tighten tolerances for reconciliation, margin call acceptance and minimum transfer amounts. A refined process could also support intraday margin calls if it were necessary, allowing a firm to quickly adjust to the changing risks associated with a counterparty.
Establishing efficient collateral management processes within individual firms and across the community is no small undertaking. There is a lot of work to be done to establish best practices, cross-industry workflows and standards. If derivatives and other innovative products are here to stay (and they are), the time has come to make the effort. There are no doubt several factors that need to be prioritized when the buy-side considers effective counterparty risk management. In order to truly help the industry progress, the buy-side must look at how to quickly implement changes to benefit all counterparties. If firms do not effectively manage our counterparty risk and have inadequate operational processes, then they are just trading off one risk for another.
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