Safe and secured?
Collateral management is integral to several activities of the modern pension fund, and the Lehman Brothers bankruptcy re-wrote its paradigms, finds Martin Steward
In a PR blunder last November, UK mortgage lender Abbey warned some of its customers that if the loan-to-value ratio on their home exceeded 90% the bank could demand payment to bring it back within threshold. You know there is a serious counterparty-credit crisis when Mr and Mrs Smith start getting margin calls.
Past corporate failures like Enron and WorldCom caused a spike in collateralisation and greater focus on the operational standards of collateral management, and the Lehman Brothers bankruptcy triggered the same thing, writ large.
"Lehman showed that any exposure needs to be collateralised," says Staffan Ahlner, head of global collateral management EMEA at BNY Mellon.
Pension funds potentially have to manage collateral across a number of transactions: if they use over-the-counter (OTC) derivatives (from equity-index futures to inflation-rate swaps) they will be managing collateral flows to and from their counterparties. But they also have an interest in monitoring other agents' processes: stock-lending programmes involve exposure to the processes used by their lending agents to manage the collateral posted by those borrowing their stock; and some of their asset managers, particularly hedge funds, will be managing collateral for their own OTC derivative positions and as borrowers of stock.
The latest ISDA Margin Survey demonstrates the effect of the credit crisis in the OTC market: the amount of collateral in circulation behind CSAs (credit support annexes) climbed to $4trn during 2008, up 86% on the $2.1trn estimated for 2007. Respondents to the survey reckoned that would swell by another 26% this year. Transactions worth tens of millions of dollars are now being collateralised, whereas counterparties would only have bothered with hundreds of millions a couple of years ago.
Quality is just as important as quantity. Increased margining frequency is perhaps the most marked post-Lehman trend: whereas the ISDA survey suggests that only 31% of the market was doing daily reconciliations during 2008, Kirit Bhatia, global head of product for collateral management at JPMorgan, is among those reporting "an aggressive move to daily margining" from clients, accompanied by a related shrinking of minimum transfer amounts from hundreds to tens of thousands of dollars. Among pension funds the move has largely been from monthly to weekly margining but, argues Olivier Laurent, director, alternative investments at RBC Dexia, "it helps to have some flexibility in your contract so that you can move to daily if the transactions start to get bigger".
All of this puts pressure on the valuation and reconciliation and processes that are the bedrock of any collateral movement.
"Inflation swaps is a good example," says Laurent. "Pension funds can have huge positions to hedge their liabilities, but these are still not pure vanilla instruments and we still have pricing differences from one investment bank to another in terms of the complexity of their models."
With more frequent reconciliations come more frequent ‘breaks' - discrepancies between counterparties' valuations of the derivative - allied with a greater concern to address and resolve those breaks before they become disputes, as opposed to letting them iron out over time. The increased operational burden that all this represents has resulted in more and more counterparties seeking out third-party custodians for collateral management to replace the bi-lateral model. And even those institutions that had tri-party collateral management in place before were probably only expecting their custodian to highlight breaks in reconciliation. Now they are expanding mandates to include better forensic explanation of those breaks so that action can be taken to resolve them as soon as possible.
Of course, one other way to handle the operational burdens of collateralising OTCs and remove the need for tri-party collateral management is to bring them onto exchanges, or at least onto a centralised clearing venue. European credit default swaps are set to move to central clearing by the end of July and the US authorities would like to see all "standardised" contracts follow suit. "But there's a lot of discussion about what that means, and as far as I'm aware there hasn't been any talk about centralised clearing for any flavour of inflation swaps," says Alyce Campbell, senior product manager for interest rate derivatives with Calypso Technology.
Pension funds' concerns about their banking counterparties should also lead to collateral management becoming a bigger part of their due diligence on their hedge fund managers.
"We had all prepared for the wrong war," as Ahlner puts it. "We prepared for a fund going down, but in the end it was a large financial institution that went down. People are now asking what happens if either party went down."
That has affected the trend around the haircuts demanded by prime brokers for both OTC and securities financing. There has been a general upward trend of tight liquidity and risk aversion in more volatile markets. But the buy-side is also wielding some power now, particularly if they are coming with large transactions, insisting that haircuts should be based on more rigorous statistical analysis of collateral portfolios to limit exposure to their prime brokers.
A more sophisticated and granular approach all-round seems to be in order: pre-Lehman US Treasuries were at 98% haircut flat; post-Lehman it is common for CSAs to define Treasuries of less than one year maturity at 98.5% haircut, 1-5 year maturity at 98% and greater than 10 years at 96%. Indeed, the buy-side is not only trying to limit the size of haircuts, it is also increasingly reluctant to keep that initial margin with its prime brokers at all.
"Hedge funds have to pay out initial margin but they realise that they don't necessarily have to keep it with their dealer," observes Jon Anderson, global head of OTC derivatives at hedge fund operations and technology specialist GlobeOp Financial Services. "A lot of people are putting in place tri-party agreements that are very valuable for protecting against initial margin exposure."
If you are posting equity as collateral and the haircut is 15-20%, that extra layer of independence and the ability to recall collateral more easily counts for a lot. "We know from PWC that, specifically on OTC derivatives, it will be a very long wait before the recovery of this 20% from Lehman Brothers," observes RBC Dexia's Laurent. "That's why we are moving towards something a little more complex."
But if initial margin is being held by a third party, how can a prime broker rehypothecate those assets to fund the liquidity that hedge funds need? According to BNY Mellon's Ahlner, this was what the industry was asking immediately post-Lehman - which is why there was a temporary move back to bi-lateral agreements.
"Institutions were not fully appreciative of the re-use functionalities that exist in the tri-party mechanisms," he says. There is a difference between rehypothecated assets and encumbered assets, he observes, so when a hedge fund places collateral with a custodian bank, prime brokers can still use it as initial margin for rehypothecation, employing the third-party custodian's operating environment to generate liquidity in the repo market. What it cannot do is use it to fund its own business. The prime broker can continue to transact with hedge funds, while the segregated custody account offers better protection of each counterparty's cash.
"You are re-using within the [tri-party custodian's] system and you have to sign up the counterparty you are going to re-use it with within that system," he explains. "But once you've done that you have an extremely efficient way to mobilise liquidity because you are not constrained by the operational issues around how many securities you can move in one day - you write one ticket and the tri-party agent takes care of the re-mobilisation of the assets you have brought in and also manages the substitution and the mark-to-market risk as it always did."
Supporters of automated tri-party collateral agreements argue that it fits well with hedge funds' multi-prime broker model - whereas a series of individual bi-lateral agreements make portfolio margining (and therefore more efficient haircutting) difficult, having an independent agent with an automated system as the hub to those spokes helps to maintain efficient and diversified collateral mobilisation.
"Our system can take the trade populations of different counterparties and reconcile them in a standardised way," says Viktor Johansson, global business manager for TriOptima's portfolio reconciliation and dispute resolution service TriResolve, used to process some 70% of non-cleared OTCs. "In addition you will be reporting your issues versus all of your counterparties in a consistent way. That creates transparency, as both you and your counterparty are looking at the same results and the same issues."
Again, all of this becomes more critical as the frequency of margining increases. If pension funds have moved from monthly to weekly, hedge funds have moved from weekly to daily.
"All the major dealers are reconciling daily, which means that buy-side participants are now able to reconcile very frequently with a sell-side that has optimised its processes," says Johannsson. "Up until a couple of years ago the process was very dispute-driven - you waited until a break occurred and then started to reconcile the trade population."
Hedge funds are much more pro-active in interrogating breaks now. This is mainly to prevent over-collateralisation, but it also helps to prevent breaks degenerating into disputes and creates a paper trail that can be tracked back a few days in the event of a dispute. The first step in reconciliation is ensuring that each counterparty shares the same conceptualisation of their transaction: if bookings are missed or other mistakes creep in, or even if one counterparty books a single trade at $100m and the other books five trades with separate funds each at $20m, these discrepancies can go undiscovered until the next reconciliation and cause big disputes if markets turn suddenly volatile.
"In a noisy market, $3m this way or that way might be $30m, and you're much better making sure that rights of dispute work well in periods of calm than waiting for the next crisis," says Globe Op's Anderson. "That's one of the huge lessons that's been learned here."
Johansson agrees, and goes further. If AIG had been reconciling their OTCs more regularly, the number and size of breaks they would have seen with their counterparties would surely have alerted them to the "significant problems" they had with their internal CDS valuation models, he suggests.
In essence, tightening standards in collateral agreements, and particularly tri-party structures, help to diversify pure counterparty risk into legal and operational risks that can be managed by independent custodians. This is beneficial to counterparties and a great opportunity for custody banks - but only if those custodians have invested in operational robustness and scalability. Diversifying risk is not the same as removing it, and pension funds in particular must resist complacency in assuming that their current custodian can provide the robustness - and independence - that their increasing demand for collateralisation will require.