As the world's largest equity derivatives clearinghouse, OCC has an innovative methodology for measuring risk and valuing collateral. It allows our clearing member firms the opportunity to post, collectively, billions of dollars less in collateral every day.
How it Works
We typically hold approximately $120 billion in collateral. Crucially, at least 70 percent of this is in equities. Since equities and equity derivatives are correlated, we're able to analyze this correlation and provide a more accurate risk assessment than if we used a standard collateral schedule.
For example, while equities are typically given a 70 percent haircut by clearinghouses when posted for collateral, OCC's methodology will often credit certain securities at greater than their market value, since they reduce portfolio risk. To allow our clearing member firms to keep abreast of this, we publish daily files of securities that are eligible for deposit along with our calculated value of each security. These files are account-specific and change as prices and the impact upon the portfolio changes.
Some clearing members have started processing these files to find the securities with the greatest value and then pledge those to OCC. This optimization may generate significant savings. Anecdotal evidence indicates that this practice may allow clearing members to meet their margin requirements by posting collateral with significantly less market value, in some cases, tens of millions of dollars less. There are also second–order savings in shifting from high-quality liquid assets like cash or government securities to equities.
Challenges to Optimization
As we expand this methodology for measuring risk and valuing collateral, we see three major challenges for our clearing member firms going forward.
- The first challenge for member firms is gathering a complete inventory of equities they have available for deposit. While this may sound simple, aggregating multiple collateral pools across large multi–national banks is no small task. Many firms are investing in technology, as well as merging related departments, so that the people responsible for determining collateral allocations have a more complete picture of the inventory.
- The second challenge for member firms is determining their internal cost model for using collateral. Following the 2008 global financial crisis, regulators implemented capital and liquidity requirements designed to strengthen banks, requiring them to set aside more capital to address exposures arising from collateral being deposited with counterparties. These requirements push down to the firms' trading desks, whose positions are generating the collateral demands. These costs are difficult to calculate accurately, since the type and source of collateral and the regulatory regimes vary by trade. As banks improve these calculations, they can optimize their trading desks and reduce their costs by using fewer high-quality assets when posting collateral.
- The third challenge for member firms is the operational process of pledging equities. Many clearing member firms still use a manual process when communicating with the Depository Trust Company (DTC) and OCC, even though we and the DTC have a real-time automated link communicating new pledges and released pledge positions. Weâve found that firms using a manual process tend to optimize pledges for operational ease rather than collateral efficiency. On the other hand, firms and vendors that automate this process tend to improve the velocity of their collateral movements and the efficiency of their deposits.
In many instances firms that addressed some or all these challenges found significant savings from their first optimization, and usually were able to maintain that efficiency with minor adjustments every three or four weeks.
OCC will continue to help our clearing members access and understand the tools available to improve their operational and collateral efficiency.
We are developing several internal systems enhancements to further support our clearing member firms' operational efficiency:
- Collateral processing with greater automation of cash and government security transactions
- Acceptance of additional types of eligible collateral
- Permitting delivery via the Federal Reserve for Escrow deposits
- Enabling clearing members to add and allocate letters of credit to their account(s) in one step.
We are also exploring ways to improve the transparency of collateral haircuts and provide additional application programming interfaces to simulate portfolios of derivatives and collateral. This may help members better understand, anticipate, and manage the risk of their clearing accounts, which, in turn, may allow them to realize significant margin savings by selecting collateral that offsets risk in their derivative portfolios.
By helping our clearing members be more efficient with their capital, improve their operational efficiency, and strengthen their resilience, OCC clears the path to a more stable tomorrow.
To learn more about OCC's thought leadership on industry issues, visit OCC's Blog.
The content in this blog was adapted from a by-lined article in Securities Lending Times 2019/20 Collateral Annual.