DTCC publishes white paper on impact of collateral settlement fails

Suggests industry-wide unsupported exposure due to collateral settlement failure for sell-side firms alone is estimated to be $27 billion
Brussels/London/New York – February 23, 2016 – DTCC-Euroclear Global Collateral Ltd, a joint venture (JV) of Euroclear and The Depository Trust & Clearing Corporation (DTCC), in cooperation with PricewaterhouseCoopers (PwC), have published the white paper, “Implications of Collateral Settlement Fails: An Industry Perspective on Bilateral OTC Derivatives.” The paper examines the market implications and costs of bilateral OTC derivatives collateral settlement fails. A collateral settlement fail occurs when cash or securities collateral is not delivered or received on the agreed date.
Beginning in September 2016, new rules for bilateral clearing of OTC derivatives are projected to significantly increase the number of collateral movements between market participants. If the current 3% settlement fail rates for collateral movements prevail, the white paper suggests that the operational cost will quickly become unsustainably burdensome, especially for buy-side firms.  At the same time, there is a risk that the problems that cause settlement fails – commonly identified as miscommunication, constrained technology, insufficient collateral and counterparty insolvency – may be exacerbated,  given the complex changes that will be required to OTC derivatives workflows and documentation alongside increased margin call volumes.
The whitepaper suggests that by 2020, the average annual operational cost of remedying bilateral OTC derivatives collateral settlement fails for survey respondents could rise 407% to $3.6 million for each buy-side firm and 377% to $2.4 million for each sell-side firm. The paper also concludes that the number of full time buy-side firm employees will increase from 4 employees in 2015 to 24 employees in 2020. Sell-side firms on average, are predicted to increase from 3 employees to 16 during the same time period.
The average annual value of bilateral OTC derivatives collateral assets received and delivered for 42 sell-side firms amounted to $889.5 billion according to the latest data from the 2015 International Swap Dealers Association Survey. Using the average collateral settlement fail rate, the annual industry-wide unsupported exposure due to collateral settlement failure for these sell-side firms is estimated to be nearly $27 billion. This figure represents the amount of uncollateralized exposure that participants experience. When also factoring in buy-side participants and the remaining sell-side participants, the overall unsupported exposure is likely to be much larger.
Regulatory mandates, including Dodd-Frank Act (DFA), European Markets Infrastructure Regulation (EMIR), and Basel III in addition to the BCBS-IOSCO uncleared/bilateral margin requirements framework, will create an increase in the number of margin calls, collateral delivery channels, and collateral movements across market participant firms. Additionally, existing collateral agreements may need to be amended, created, or replaced to comply with regulatory requirements. The breadth and depth of these regulations pose significant challenges for participants in the bilateral OTC derivatives market.
Michael Shipton, Chief Executive Officer, DTCC-Euroclear GlobalCollateral said: “There seems to be disconnect in the market, at present. Industry participants are focused on the new uncleared margin regulations, but are not considering the operational challenges of increased collateral movements that may result in collateral settlement fails. The purpose of this whitepaper was to shed some light on the serious impact that these fails pose to the market.”
Mark Jennis, Executive Chairman of DTCC-Euroclear GlobalCollateral added: “It is becoming increasingly important that firms assess and improve their current collateral and margin management processes, as regulatory obligations continue to increase. With current rate of collateral fails, combined with the expected increase in margin and collateral calls, firms must act now and ensure they can meet these impending challenges.”
Thomas Ciulla, Principal, PwC concluded: “While industry attention is focused on the impact and implementation of regulatory mandates that include uncleared/bilateral margin requirements, collateral settlement fails tend to escape closer scrutiny.  A persistent issue now, due in part to simple counterparty miscommunication and constrained technology, collateral settlement fails will rise in proportion to the increased collateral movements that are a result of new uncleared/bilateral margining rules.  The resulting operational and liquidity impact will be material and demand remediation.  This timely paper explores the reasons for fails and more importantly, how they can be reduced.”
The information in the white paper was collected through interviews with collateral settlement specialists operating within the OTC derivatives marketplace. The respondent breakdown consists of: asset managers (33%), dealer banks (25%), custody banks/outsourcers (25%), insurance firms (8%) and technology vendors (8%).

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