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 per cent 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 per cent. 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.
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.
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© IPE International Publishers Ltd.
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