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This edition first published 2018
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Library of Congress Cataloging-in-Publication Data
Names: Simmons, Michael, author.
Title: Collateral management : a guide to mitigating counterparty risk / Michael Simmons.
Description: Chichester, West Sussex, United Kingdom : John Wiley & Sons, 2019. |
Series: Wiley finance series | Includes bibliographical references and index. |
Identifiers: LCCN 2018043094 (print) | LCCN 2018044295 (ebook) | ISBN
9781119377108 (Adobe PDF) | ISBN 9781119377122 (ePub) | ISBN 9780470973509
(hardcover)
Subjects: LCSH: Collateralised debt obligations. | Credit derivatives. | Security (Law)
Classification: LCC HG6024.A3 (ebook) | LCC HG6024.A3 S556 2019 (print) | DDC
332.64/5—dc23
LC record available at https://lccn.loc.gov/2018043094
A catalogue record for this book is available from the British Library.
ISBN 978-0-470-97350-9 (hardback)
ISBN 978-1-119-37710-8 (ePDF)
ISBN 978-1-119-37712-2 (ePub)
ISBN 978-1-119-37717-7 (obook)
Cover Design: Wiley
Cover Images: © KJ_Photography/Shutterstock; © agsandrew/Shutterstock; © Alex Staroseltsev/Shutterstock; © ESB Professional/Shutterstock
For Allyson, Keir and Freya
The collateral management processes rapidly developed during the past decade; after the financial crisis of 2008 there was a significantly greater need to reduce counterparty credit risk in a more efficient way. Not only the market participants but also the regulators expressed this requirement. The G20 summit held in Pittsburgh in 2009 focused on the financial markets and world economy, following which a range of major new regulations were drafted. These were implemented in several phases and are better known as Dodd-Frank and EMIR regulations.
The main reason for a firm to implement a collateral management process is to reduce counterparty credit risk via the exchange of collateral; this is generally achieved via cash or securities. This hasn’t changed in essence since the financial crisis; however, the frequency, processes and products covered have changed. The regulations have had a huge impact on the used applications and processes, from additional trade reporting, trade reconciliations, daily margining, lower minimum transfer amounts, same day settlement, through to the exchange of initial margin with central counterparties.
As an industry expert I’ve experienced these developments directly, this is also the reason why I would like to share my personal view in this Foreword. Where ten years ago the process was executed by almost every market participant in Excel and Access on a weekly to monthly basis, the financial crisis was definitely the catalyst for change. Software vendors started to build systems supporting the gathering and storing of the most crucial information. This developed further to workflow systems with a high STP rate, often connected to trading systems. Connections were established via APIs, S.W.I.F.T. or SFTP with internally used systems, and with banks, custodians and other service software providers. Alongside such developments new systems assisting the workflow became part of the collateral architectural landscape; some generally accepted systems are triResolve and MarginSphere. (These additional applications will become of considerable benefit to the global collateral environment once adopted by a significant portion of market participants.)
Some years ago the collateral process was mainly focused on bilateral OTC Derivatives, with some additional Repo collateralisation. Now we see many different products subject to collateral, all supported by their own legal documents. Examples of the most frequently traded products in addition to those above are Centrally Cleared Derivatives, Mortgage-Backed Securities and Securities Lending. Additionally, the number of parties now required to exchange collateral has drastically increased due to greater regulation.
As author of this book, Michael Simmons has combined his industry knowledge, training experience and work experience with his enthusiastic interest in collateral management. This book will become essential reading for everyone working within collateral management (whether focused on repo, or securities lending, or derivatives – or all three topics), as it touches the necessary level of detail to gain a broad understanding of the products requiring collateral, as well as the collateral management process itself.
Guido Verkoeijen
Team Manager Cash & Collateral Management
APG Asset Management, The Netherlands
Once it became clear that the profile and importance of collateral management had risen significantly following the 2008 Global Financial Crisis, I sensed there was a growing need for a significantly greater understanding of collateral management amongst operations (and other) personnel working within the financial services industry.
In order to understand the subject to enable me to write such a book, I needed access to those that had insight on the subject.
In particular, I would like to thank Guido Verkoeijen for his explanations of both concepts and detailed points, and for his care and patience in reviewing a significant portion of the text.
I would also like to thank Hasse R. Brandt for his expertise and perspective on a range of topics, as well as time spent reviewing my draft chapters.
Other people that have contributed significantly are:
for which I thank them greatly.
Michael Simmons
Michael (Mike) Simmons is an operations specialist, having spent his entire career focused on hands-on tasks, management and education relating to the various post-trade execution processes. Having spent over 20 years within a blue chip investment bank (S.G. Warburg and Warburg Securities) where he was the manager of Fixed Income (Bond) Operations, Mike then began writing and delivering training courses on behalf of a number of organisations, including the International Capital Market Association (ICMA). He is the author of two previous books, namely Securities Operations and Corporate Actions (both published by Wiley).
Mike’s interest in Collateral Management arose as a result of the Global Financial Crisis in 2008, where it became very apparent that the profile of the topic had increased dramatically, compared with pre-crisis. In addition to existing collateral-related transaction types such as repo and securities lending, the introduction of mandatory central clearing for OTC derivatives in all jurisdictions globally meant there was suddenly a hugely increased focus on collateral which impacts both buy-side and sell-side firms, and other organisation types such as central securities depositories, custodians, management consultants and software providers. Under such circumstances, Mike felt there was a real need for education of operations and other personnel in the topic of collateral management.
Today, as a freelance trainer and consultant based in the UK, Mike delivers training courses on a range of operational topics both in the UK and overseas. Courses include collateral management, the securities (equity and bond) trade lifecycle, corporate actions, repo, securities lending & borrowing, and OTC derivatives incorporating both centrally cleared and non-centrally cleared trades. He also wrote and frequently delivers the 5-day Operations Certificate Programme (a 5-day multi-subject examined qualification) for ICMA Executive Education.
Observations on the style and content of this book can be conveyed to the author by email to info@mike-simmons.com.
Within the financial services industry, on a daily basis cash and securities are lent to borrowers on a temporary basis. In order to mitigate (reduce) the lender’s risk of the borrower failing to return the lent cash or securities, other assets of value are given by the borrower to the lender. Such other assets are generically known as ‘collateral’.
Additionally, collateral plays a major role in mitigating counterparty risk associated with OTC derivative transactions, in products such as interest rate swaps and credit default swaps.
Transactions including cash lending, securities lending and OTC derivatives are executed by buy-side firms (including pension funds, insurance companies, asset managers and other corporate entities) and sell-side firms (including investment banks and brokers). Consequently, collateral is relevant to both the buy side and the sell-side of the business.
For a number of years prior to the autumn of 2008, collateral had been used for OTC derivatives with the passing of collateral between trading parties occurring, in some cases, weekly or every 2 weeks or even monthly. Up to that point in time, usually only the larger financial services firms identified exposures and then gave or received collateral as frequently as daily.
Then came the Global Financial Crisis and the financial industry turmoil in October/November 2008. Both during and since the downfall of Lehman Brothers, the profile of collateral management has risen dramatically, and firms of all sizes are now actively using collateral to mitigate exposures as a primary counterparty risk mitigation measure, on a daily basis.
The degree of complication within operations departments has consequently multiplied greatly. Successful processing of collateral within an organisation requires knowledgeable staff who understand the component parts that lead to safe and secure processing, and awareness of the pitfalls that can result in unacceptable exposures. The efficient and successful collateral department within a financial services firm demands a highly unusual mixture of knowledge and know-how of a number of connected financial services operational disciplines.
The combination of new players in and the increased frequency of collateral management around the globe means that basic knowledge of the subject is in short supply and in big demand: many of the positions advertised currently by financial services firms are collateral management jobs. Risk management professionals need an excellent understanding of this topic in order to appreciate whether counterparty risk is in fact being mitigated. Lawyers negotiating legal documentation necessary to be signed prior to trading should ideally understand the overall collateral process. Those working within central securities depositories and custodians should appreciate the topic if they are to understand and comply with the securities and cash movements instructed by their clients. Consulting firms also need to understand the subject if they are to provide expertise into financial services firms. Software firms need to become aware of the topic if they are to provide collateral management systems that meet their clients’ collateral objectives.
Collateral management is applicable to financial institutions globally.
This book is targeted towards those wishing to gain an all-round understanding of collateral management, from an operations (processing) perspective. Therefore, those that will find this book of value include:
This book describes the essential day-to-day and detailed practices that 1) a collateral professional requires, and 2) are necessary for a firm to achieve counterparty risk mitigation in a secure fashion and without introducing further risks.
Furthermore, this book is designed to enable readers to make a very positive connection between the conceptual need to minimise counterparty risk, and what must be done in practice in order to achieve counterparty risk mitigation.
The objective of this book is to demystify the subject of collateral management by breaking the subject into logical components, explaining the issues relating to each component and at the same time conveying the accumulated effect and the overall picture.
In order to aid the reader’s understanding, approximately 150 diagrams are contained within the text. Furthermore, the text contains example calculations to facilitate the reader’s complete understanding.
Towards the end of the book, the reader will find an extensive Glossary of Terms containing over 600 words and phrases relating to the subject of collateral management.
The book is structured to be read chapter-by-chapter, from the beginning to the end. However, in recognition that some readers may prefer to target certain parts of the book (e.g. Part 3: Securities Lending & Borrowing and Collateral), each Part has been written as a standalone topic.
The book is divided into four parts. Part 1 begins with a number of fundamental but important concepts; firstly, an explanation of elementary collateral principles, following which the features relating to types of collateral are described.
Thereafter, the three main transaction types which necessitate collateral are described, namely:
Part 4 is significantly larger than Parts 2 and 3, consequently there are three sections to Part 4:
I have written this book entirely independently; the views expressed within are my own and not the views of any organisation with whom I have been associated, whether as an employee or as a trainer or as a consultant.
Although every effort has been made to remove errors from the text, any errors that remain belong to me. If readers have comments on the content and style of the book, I would welcome such comments; I can be emailed at info@mike-simmons.com.
Michael Simmons