Collateral Management:

The Rise of Automation

An Industry Discussion

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Collateral Management: The Rise of Automation

The global financial crisis of 2008 is considered by many economists to be the worst financial
crisis since the Great Depression of the 1930s. It resulted in both the collapse and the threat of
collapse of major financial institutions, government bailouts, and downturns in stock markets
around the world. The crisis played a significant role in the failure of key businesses, declines in
consumer wealth estimated in trillions of US dollars and a downturn in economic activity leading
to the 20082012 global recession, as well as contributed to the European sovereign-debt crisis.

While there were many causes of the crisis, one of the primary reasons for the downfall was the abundance
of high risk, complex derivative transactions in the market, often used by financial institutions to leverage
against their existing capital. When valuation volatility occurred, the lack of robust risk monitoring and nonoptimal collateral management processes limited firms ability to meet their obligations. In many instances,
due to substandard technology and silod operations, institutions were unable to calculate or monitor their
exposure to counterparty default risk. Firms simply could not ascertain, with a reasonable level of accuracy,
how exposed they were to any specific counterparty.
In other instances, some counterparties of defaulting entities, such as Lehman Brothers, had not properly
collateralized their exposures to the bank, taking volatile or non-liquid collateral, or accepting collateral
concentrated in sectors or from issuers who were also at risk of default. This left these counterparties with
significant exposures and unidentified losses.
Further, legacy collateral practices caused many firms to over collateralize their obligations. Many firms
holding out-of-the-money positions had excess collateral held with defaulting counter-parties, including
Lehman. As a result, when the firms collateral was comingled with the defaulting counter-partys assets,
and managed by a bankruptcy trustee, these firms essentially became unsecured creditors and were
exposed to haircutting or significant delays in the return of these assets to their rightful owner.
The Evolving Regulatory Landscape
In response, as a result of the crisis, we have seen an explosion in financial markets regulation around the
world. While Dodd Frank, Basel III, Solvency II and EMIR are well known, many sovereign regulators are also
increasing scrutiny surrounding risk management practices to try to minimize the factors which led to the
2008 financial crisis. Market participants worldwide will need to comply with these new regulations in a timely
and efficient manner, at a time when many of the mandates are still in the formative stage. As volumes return,
firms will struggle with how to meet these regulatory obligations and manage their operations given the
preponderance of legacy approaches to collateral management today.

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Collateral Management: The Rise of Automation

The Rise of Collateral Management Automation

Global investment managers are exposing themselves to significant counterparty default risk due to
challenges in monitoring and managing counterparty exposure. The firms that do not monitor and mitigate
this risk with daily collateral calls remain exposed to significant losses should a counterparty default. The
risk is not only in the loss of a non-performing derivative contact that is in the money, but there is a potential
loss if a manager is over-collateralized at a defaulting broker and is unable to retrieve the over collateralized
amount. Daily exposure monitoring and collateral management is required to minimize the potential
for these losses.
Today, many firms are beginning to implement robust, automated collateral management solutions to bolster
their operational and risk management capabilities in support of evolving regulatory demands. In doing so,
clients gain real-time transparency into their collateral exposure and counterparty risk across their portfolio
of investment activities.
Lets look more closely at some of the drivers that will require firms to evaluate their operations and embrace
increased automation. These factors include the introduction of a mixed clearing environment, volume
pressure, collateral optimization and concentration limits.
1. Mixed Clearing Environment
Standardized derivative contracts will now be subject to central clearing requirements. Central clearing
covers standard over-the-counter (OTC) instruments only, thus requiring collateral systems to manage
exposure for both cleared and bi-lateral OTC agreements in addition to other asset classes.
While most OTC derivatives will be centrally cleared, many will remain bi-lateral due to their complexity
or lack of liquidity. This bifurcated environment will result in a mixed clearing environment, where
participants will need to manage collateral via two very different operational flows. If a counterparty
defaults, a firm is exposed to losses stemming from the multiple business lines of that counterparty.
These exposures can include exposures to counterpartys OTC derivative desk, cleared OTC and/or
exchange traded derivative desk, and their Repo desk, to name a few.
To accurately monitor and manage this risk, best practice dictates that a firm should engage in holistic
collateral managementmanaging collateral for all collateralized instruments on a single system,
across central and bi-laterally cleared trades. To achieve this, collateral operations and technology
must have the ability to accommodate all of the workflows in a mixed clearing environment.

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Collateral Management: The Rise of Automation

2. Volume Pressure: Increased Number of Margin Calls

Additionally, with the move to central clearing, investment managers face an exponential increase
in the number of margin calls, which will strain already tight operational resources. Based on
feedback from a number of the worlds leading financial institutions combined with recent research
on projected derivatives growth, Omgeo estimates that central clearing of OTC derivatives will
result in a 600% increase in the number of collateral/margin calls that need to be processed.
All cleared derivatives will be subject to calls for both initial and variation margin. This is not
universally the case in todays bi-lateral world. Currently, calls generally need to exceed a certain
dollar amount for them to be delivered to the counterpartycalled a threshold and minimum
transfer amount. In a centrally cleared environment, calls are required for both initial and variation
margin. As a result, it is estimated that for every one call today, an investment manager will be
subject to 6 calls in the new environment. At the same time, the mixed clearing environment will
create an increased number of collateral relationships with new counterparties.
This drastic increase in call activity and counterparties is projected to increase the cost of
operations as well as test whether firms have the right levels of straight-through-processing (STP),
automation and controls in place. With automation, the call process becomes volume insensitive,
enabling firms to achieve scalabilitywith the same resourcesin an efficient and timely manner.
A lack of automation will open a firm up to not only increased risk, but will significantly increase
a firms operational costs due to manual processes.
3. Collateral Optimization
Silod collateral departments dont allow an organization to effectively manage the collateral
process, understand the firms total counterparty exposure, optimize the use of collateral across
the enterprise, or take advantage of potential operational efficiencies. With the expectation that
there will be an increased focus on the quality of collateral, there will be an overriding need for
buy-side firms to be able to optimize their collateral usage through the improved, management
of their margin and collateral calls, as well as for consolidated reporting purposes.
Silod collateral departments make this impractical or impossible. A firm must align their
operations and technology to monitor exposure and manage collateral across all instrument types
and asset classes. In doing so, they gain the ability to monitor aggregated entity level risk and
manage and use, their collateral more effectively. Improved allocation processes will certainly
make firms smarter around their use of collateral, and it is an area of operational investment that
is urgently needed across the globe.

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Collateral Management: The Rise of Automation

4. Concentration Limits
Of the firms that manage their counterparty risk on a daily basis, many are unaware of their
concentration risk. As firms discovered during the financial crisis, even if they held collateral to
cover their counterparty risk, during times of market stress, the value of the collateral, especially
collateral whose value was tied to specific sectors or issuers, fluctuated significantly resulting in
large uncollateralized exposures. This problem is exacerbated when collateral is managed in siloes.
However, more sophisticated managers have since placed concentration limits on the collateral
they accept. Firms must not only ensure that they take in the appropriate amount of collateral, but
they must monitor the types of collateral accepted to ensure that their collateralization levels are
not disproportionately impacted by market fluctuations of a specific asset class, sector or security.

Moving Forward: Lessons Learned

More than ever, with todays evolving regulatory and trading environment, market participants must rely
on smart, adaptable solutions that grow as their business expands and meet emerging industry and
regulatory demands. Rapidly changing regulations around the globesuch as CFTC/Dodd-Frank Act,
ESMA/EMIR, and IOSC/Basel IIIare challenging firms abilities to comply with requirements across
jurisdictions. Specifically, industry participants need to ensure they have a solution that mitigates risk,
processes collateral information consistently across clearing methods and asset classes, and meets
new regulation and industry best practice.

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Collateral Management: The Rise of Automation

About Omgeo
At Omgeo, we are the operations experts, automating trade lifecycle events between investment managers,
broker/dealers and custodian banks. We enable 6,500 clients and 80 technology partners in 52 countries
around the world to seamlessly connect and interoperate. By automating and streamlining post-trade
operations, we enable clients to accelerate the clearing and settlement of trades, and better manage and
reduce their counterparty and credit risk. Our strength lies with our global community and our ability to
adapt our solutions to enable clients to realize clear returns on their investment strategies, while responding
to changing market and regulatory conditions. Across borders, asset classes, and trade lifecycles, Omgeo
is the global standard for operational efficiency across the investment industry. Formed in 2001, Omgeo is
jointly owned by the DTCC and Thomson Reuters. For more information, please visit www.omgeo.com
About Omgeo ProtoColl
Omgeo offers a collateral and margin management solution, Omgeo ProtoColl, which helps firms to track
and optimize their collateral bookall from one centralized workflow location. Omgeo ProtoColl is the
most complete and user friendly collateral management solution available today, automating the margin
call process via an efficient exception management based workflow.
Omgeo ProtoColl supports collateral management processes across all traded asset classes including
margining of derivatives, repos, and securities lending. Users take advantage of a flexible, robust
collateral and margin management solution that automatically monitors the terms of their agreements
and credit support annexes (CSAs) across a broad spectrum of margining models and product coverage.
The solution automatically calculates excess/deficit margin requirements for each active transaction
portfolio, generates the necessary margin calls, and produces the associated notifications. It also handles
call negotiations, processes the mitigating collateral orders, and ultimately helps users track and optimize
their collateral bookall from one powerful and intuitive platform. To learn more, please visit
www.omgeo.com/protocoll

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