One of the key points of EMIR, central clearing of OTC derivative transactions, has now become a fact of life. In its wake, liquidity management and management of liquidity risks are receiving increasingly close attention. While the discussion around whether pension schemes should be exempt from EMIR continues, schemes should carefully think about these issues in the meantime.
24 Mar 2016
The custodian plays an important, if not essential role in the collateral management process and management of the liquidity risk.
In the run-up to the introduction of the European Markets Infrastructure Regulation (EMIR), many market parties complained that the implementation would cost too much time and money and would create too many operational problems. However, as with all regulation, its introduction is inevitable. That was clearly in evidence, for example, at the Collateral Management Event on 10th and 11th December in Amsterdam, where I had the honour of serving as a Day Chairman. The different presentations showed that the various parties concerned are genuinely starting to embed EMIR in their day-to-day practice. Attitudes to EMIR are clearly shifting towards a more pragmatic approach. In that regard, it is primarily the issue of risk mitigation that is interesting.
EMIR was created in order to further reduce and manage the risks relating to derivatives. One of the measures is mandatory clearing of OTC derivative transactions via a central counter-party (CCP). Many parties use a General Clearing Member (GCM) for this; but how do you assess the counter-party risk on the GCM you have chosen? What happens if the GCM defaults or even fails? Might it be better to do the clearing yourself by affiliating yourself to the CCP? And in that case, how should you do that?
These are important questions in the set-up of the risk management process, as is the question of ‘Which risks will we lose and which will we acquire in return?’ Liquidity risk is currently identified as the main risk. The market appears to be hoping that the Dutch regulator De Nederlandsche Bank (DNB) will suddenly magically whisk a white liquidity rabbit out of the supervisory hat. I personally think that until we come up with a workable proposal for managing liquidity risk, the DNB will not move either. This means that pension funds, insurers, banks, CCPs and all other participants must put their heads together to find a workable solution within the existing laws and regulations.
What are you prepared to pay for it?
Another interesting question is what risk mitigation is going to cost. Clearing makes a difference in the price of swaps, for example, because it saves operational costs. At the same time, you incur costs in generating the right collateral that must be deposited with the CCP (if, of course, you do not have the right collateral). For the supervisory authorities the situation is very interesting. The presentation by the DNB shows that it is entirely inflexible about the ‘Yes/No’ question relating to compliance with the EMIR requirements. But once you have said ‘Yes’ to the concept of clearing derivatives, the DNB can be very accommodating in the discussions. However, whether that will also be the case in practice still remains to be seen.
Supervisory authorities know what has to happen, they know the problems and they monitor the market; but they have also become a little nervous, due to the initial problems with EMIR. For some parties, for example, mandatory reporting of derivative transactions to trade repositories has turned into a real drama. Some reports have disappeared, while others are incorrect. A number of parties have said that they cannot make reports.
In the meantime, the supervisory authority has become convinced that this must now simply be properly regulated, with the effect that the role of the custodian is becoming increasingly important in the EMIR process.
Role of the custodian
Market parties regularly complain about the GCMs. Collateral management and liquidity management do not always proceed as expected. Increasingly, the custodian is the party who comes to assist when matters threaten to go completely wrong. Custodians are increasingly developing into ‘trusted partners’ for the party that is to perform clearing. This is also seen in ‘quad models’, in which a pension fund, a clearing member, the CCP and the custodian jointly secure the initial margin for the pension fund. Of the four parties, the custodian is trusted most.
This makes generating liquidity via a custodian an interesting option. A major bank can help to generate collateral/liquidity on the basis of its client’s bond portfolio. But it can take a while before the securities are where the client wants them, with the CCP. A custodian has an insight into all the places where securities are kept and the availability of securities in the client’s bond portfolio. As a result, the custodian can quickly transfer the securities and thus make them available as the right collateral in the right place.
In that way, the custodian plays an important, if not essential role in the collateral management process and management of the liquidity risk. Institutional investors, in particular, can benefit from this.
Geert-Jan Kremer, Managing Director Treasury at KAS BANK