October 6, 2017 / 11:30 AM / a year ago

Buyside faces collateral cliff as margining hits FX forwards

LONDON, Oct 5 (IFR) - A long tail of buyside firms will be forced to collateralise currency hedges from January, as sweeping European reforms bring trillions of dollars of FX forwards into scope for variation margin payments.

The contracts, which were initially excluded from uncleared margin requirements under the European Market Infrastructure Regulation, will join FX swaps and non-deliverable forwards in the regulatory net following implementation of MiFID II, which includes the instruments in its definition of derivatives and subjects them to EMIR requirements.

For buyside firms, timely compliance is an uphill struggle as many are new to collateralisation and lack the technical resources and personnel to implement necessary changes.

“There are a lot of long-only funds that don’t really trade derivatives but do trade FX forwards so it will apply to a lot of firms who have never collateralised before,” said David White, head of sales for triResolve, a division of NEX Group that performs portfolio reconciliation and margin calculations. “There’s a lot of learning and repapering to do in quite a short space of time.”

Funds that trade a small amount of derivatives and have collateral infrastructure in place to handle low volume face an exponential increase in the number of collateral calls, forcing them to adopt automated processes.

Equity fund managers face a complex task collateralising FX derivatives, particularly within a UCITS framework, as they only hold equity securities. Stocks can be difficult to post as collateral outside of a triparty platform given valuation issues around haircuts and corporate actions.

In anticipation of the challenge, BNP Paribas Security Services this week became the first new entrant in the triparty collateral management arena for almost two decades with the launch of a platform that aims to connect buyside and sellside firms for more efficient collateralisation across a wider range of securities.

It is not just European firms that are feeling the heat. FX derivatives are exempt from uncleared margin requirements under Dodd-Frank but US firms face challenges when trading with European counterparties given specifics around how collateral is managed in each region.

“There are going to be a lot of challenges as certain types of US funds are not allowed to physically deliver collateral outside their custodian, so they have to segregate their collateral,” said Ted Leveroni, chief commercial officer at GlobalCollateral, a collateral processing company. “European dealers have to figure out how to process that and set up triparty custody accounts with their buyside counterparty’s custodians, which is very foreign to them.”

That could mean some US firms are cut off from transacting with EU counterparties, posing a liquidity threat as the market fragments into regional hubs.

“From an operational risk perspective, the worst conversation you can have with the front office is that they have to change the way they trade, or the counterparties they trade with,” said Leveroni. “US firms are doing their best to ensure it doesn’t come to that.”

Despite the scale of the task for buyside firms, those facing margining for the first time have new tools at their disposal. Collateral management has already been through something of a revolution with off-the-shelf documentation and range of optimisation platforms promising greater automation, dispute management and more efficient processing.

“Margin rules have been a mandate for standardisation in a market traditionally muddled with bespoke agreements. In collateral management, if you open yourself up to margin inefficiencies, you potentially open yourself up to funding inefficiencies,” said White. (Reporting by Helen Bartholomew)

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