GLOBAL – Institutional investors should explore alternative sources of collateral for derivatives trades at a time when regulatory reforms are expected to be a new "cost burden" for market players, BNY Mellon has warned.

In a paper entitled "To clear or not to clear: Collateral is the question", BNY Mellon said institutional investors were currently facing "substantial" business and operational challenges around executing, clearing, collateralising and reporting OTC derivatives trades due to the arrival of the Dodd-Frank Act in the US and the EMIR text in Europe.

Additionally, BNY Mellon stressed that institutional investors should be particularly aware of the amount of initial margin required under the central clearing system.

The report noted that an initial margin obligation for a five-year vanilla interest rate swap might be equivalent to 1-3% of the notional value of the contract agreed with the bank.

The same amount for long-dated or more complex contracts might go up to around 10%.

BNY Mellon therefore called on institutional investors to find alternative eligible collateral, as the traditional government bonds, cash or high-quality securities required by central clearing houses might prove too expensive to acquire.

One solution would be via the use of "collateral upgrade" – also called "transformation".

The collateral transformation process allows pension funds and other customers to swap lower-rated securities that do not meet CCP-eligibility standards for "better" quality assets such as government bonds, high-quality securities or cash.

Nadine Chakar, executive vice-president for global collateral services at BNY Mellon, said: "There is an opportunity here for those institutional investors that are natural holders of CCP-eligible collateral, and these assets will be subject to intense demand from banks and other institutional investors to cover margin.

"The ability to lend such assets – subject, of course, to adequate risk controls – could therefore be a means of offsetting some of the costs of compliance with the new rules, as well as augmenting depressed yields."

However, BNY Mellon also conceded that this option presents major drawbacks.

While transformation might lead to "substantial" over-collateralisation, it might also lead to the introduction of additional costs in the form of fees and operational overhead, which must be borne by the fund.

Meanwhile, BNY Mellon established some steps investors would need to follow to post their margin calls under the new mandatory clearing system.

First, the report stressed, institutional investors should review their OTC derivatives strategies to establish which cleared contracts will be used and then model the initial margin requirement of the current or projected OTC derivatives portfolio.

Investors should also identify all incremental costs under the new rules, as well as consider strategic and tactical changes to the investment process and evaluate the service offerings that can mitigate costs.

The asset manager concluded that a more proactive approach to sourcing eligible assets was appropriate when it came to limiting the cost of the changing collateral burden precipitated by new regulations.