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How to Improve Returns with Better Collateral Management

There is no doubt about it ‚Äď multi-currency collateral management is now an integral part of overall risk management. This is particularly true as regulations push to collateralize¬†funding of derivatives, and require more derivatives to be centrally cleared. The increase in collateralization is making multi-currency derivatives strategies increasingly more complex.

But, what triggered the increased emphasis on collateralization in the first place? Well, if we learned anything from the global financial crisis, it was that a great many deals and institutions were severely under collateralized. In part, this reality fostered mistrust and led to an eventual freezing of certain markets. Learning from these lessons, we are now seeing an unprecedented increase in demand for collateral, particularly in the area of OTC derivatives.

As we all know, there are many regulations now keenly focused on ensuring deals are properly collateralized. For instance, EMIR mandates the clearing of liquid swaps on central counterparties (CCPs), with the goal of reducing counterparty credit risk, improving the transparency and efficiency of collateral management, and increasing the transparency in the OTC derivatives markets. At the CCPs, both buy-side and sell-side institutions are required to post initial margin and variation margin, typically in the form of high quality liquid assets (HQLAs).

Then there is Dodd-Frank, which lays the foundations for new categories of trading venues. Its mandate requires that all derivatives trading that is sufficiently liquid, and eligible for clearing, will take place on some regulated trading venue, either an organized trading facility (OTF) or a multilateral trading facility (MTF).

Last and certainly not least there is Basel III, which requires an amendment to credit support annexes (CSAs), whereby an exchange of variation margin between bilateral counterparts, for OTC derivatives instruments, that are not centrally cleared is now necessary.

What all this means is that within banks, collateral management is moving from a lesser back-office function to a strategic initiative intended to drive competitive advantage. As such, firms are increasingly investing in systems that improve transparency, provide a central view of collateral, and enable a more holistic approach to collateral optimization.

Having a complete understanding of risk is key to optimizing collateral. In order to gain this comprehensive view of risk, institutions need the ability to accurately incorporate the FX exposure from their multi-currency collateral management. The problem is that some firms systems are ignoring the FX basis risk inherent in the underlying collateral agreements for their multi-currency derivatives strategies.

So what is the best way to remedy this issue? More institutions are electing to integrate their FX collateral management directly into their derivative valuation and risk framework. This approach is helping them achieve more accurate and comprehensive risk reporting, better hedging and improved returns.

Using FINCAD F3, our portfolio and risk solution, numerous firms have benefitted from taking a more holistic and more accurate approach to risk management. With a consistent, arbitrage-free view of risk, you will be able to get a more precise understanding of your exposure. Consequently, you will be empowered to take a more strategic approach when formulating the most cost-effective hedging and collateral management strategies possible.

Learn more about this topic by reading our popular eBook: Uncovering Derivatives Hidden Risk: Best Practices for Multi-Currency Portfolios

About the author

James Gavin's picture

James Gavin

Lead Derivatives Analyst and Head of Professional Services-Americas, FINCAD

As a Lead Derivatives Analyst and Head of Professional Services -Americas, James supports complex FINCAD implementations for clients. These implementations have included highly structured trades and portfolio level solutions such as VaR, CVA and P&L attribution. James also provides project management and quantitative input on project implementations. James comes to FINCAD with a B.Sc. in Financial & Actuarial Mathematics and an M.Sc. in Finance and Capital Markets from Dublin City University (Ireland).

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