OTC Derivatives Collateral Management: Improve the Process to Reduce Risk

Published by: TowerGroup

Published: Aug. 4, 2008

Table of Contents

Report Coverage

Vision

Collateral Management Spans OTC Processes

Amount and Types of Collateral

OTC Volumes

Hedge Funds

Credit Concerns

Regulations

Improvement Opportunities

Consequences of Doing Nothing

Summary

Abstract

Report Coverage

Bear Stearns collapsed. The debt and equity markets are tumultuous. The smooth operation of the credit markets depends on faith that counterparties can pay their obligations. The fundamental underpinning of the market is being tested, especially in over-the-counter (OTC) derivatives. Chief risk officers are under a great deal of stress, leading to a focus on collateralization (and a few sleepless nights). This Research Note examines inadequacies in the OTC derivative collateral management process as well as the ways the collateral management function will evolve and the ways that evolution will drive technology.

A forthcoming TowerGroup Research Note will discuss the key vendors that provide collateral management technology to financial service institutions.

TowerGroup Take-Aways

• The securities industry is increasingly collateralizing over-the-counter (OTC) derivatives, so broker-dealers must fully integrate their collateral management application with their OTC derivatives trading platform.
• Financial services institutions will increase their use of noncash collateral, necessitating robust collateral servicing and portfolio optimization engines.
• TowerGroup recommends that the securities industry develop messaging standards, an industry infrastructure, and protocols to improve the processes for collateral calls.
• Broker-dealers that do not effectively and proactively manage collateral will expose themselves to counterparty credit risk and face a potential loss of order flow.
• Buy-side firms' use of sophisticated collateral management technology will increase as portfolio managers that pledge cash because of its operational efficiencies take risks with investment performance.
• Firms must prepare for cross-product collateral management — which focuses on margining across OTC derivatives, repo, and securities lending groups — to be a standard part of the margining process by the end of 2009.

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