BNY Mellon - Rule Financial paper highlights pressing need for institutional investors to explore alternative sources of collateral

London - 14 December 2012

A more proactive approach to sourcing eligible assets could limit cost impact of new regulations

A new paper published by BNY Mellon, the global leader in investment management and investment services, in association with specialist banking consultants Rule Financial, examines the profound impact that the fundamental post-crisis regulatory reform of the OTC derivatives markets will have on all users of those instruments.

The paper, entitled 'To Clear or not to Clear...Collateral is the question', looks at what avenues are open to institutional investors who - with the advent of the Dodd-Frank Act, EMIR and other equivalent rules - face substantial business and operational challenges around executing, clearing, collateralising and reporting OTC derivatives trades.

Banks, facing comparable challenges, are investing in collateral optimisation projects that seek to maximise the efficiency with which assets are sourced from across their firm to meet collateral obligations.

While the applicability of collateral optimisation can be considered to be diminished for institutional investors because of the fragmentation of assets under management into discrete portfolios, the paper concludes that a more proactive approach to sourcing eligible assets is appropriate when it comes to limiting the cost impact of the changing collateral burden precipitated by new regulations.

The paper outlines five additional steps that - assuming regulatory exposure is understood - that portfolio managers may take to achieve the goal of cost limitation:

-- Review OTC derivatives strategy to establish which cleared contracts
will be used.
-- Model the initial margin requirement of the current or projected OTC
derivatives portfolio.
-- Identify all incremental costs under the new rules.
-- Consider strategic and tactical changes to the investment process.
-- Evaluate service offerings that can mitigate costs.

Accordingly, as a matter of priority institutional investors should be engaging with their clearing brokers and custodians to evaluate alternative sources of collateral - and, where necessary, agree on changes to investment mandates and counterparty documentation to work towards ensuring that all potential benefits are realised.

Nadine Chakar, executive vice-president for Global Collateral Services at BNY Mellon, said: "There is an opportunity here for those institutional investors that are natural holders of CCP-eligible collateral, and these assets will be subject to intense demand from banks and other institutional investors to cover margin. The ability to lend such assets, subject of course to adequate risk controls, could therefore be a means of offsetting some of the costs of compliance with the new rules as well as augmenting depressed yields."

Jonathan Philp, specialist in OTC clearing & collateral management at Rule Financial, said: "One impact from a portfolio management perspective is the increase in collateral that must be provided to support OTC derivatives activity, whether cleared or not. The danger is that the perceived benefits of central clearing are overwhelmed by the unintended consequence of the costs of compliance being passed through to the policy holder and pension scheme member, for example, whether in the form of constrained, sub-optimal portfolio decisions or the direct costs of adapting to the new market structure."

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