Enhancing the Security Handling for Derivative Transactions
- Peter Johnson
- Dec 9, 2023
- 3 min read
In 2017/2018, I recall trying to create a coherent structure for my own #humanGPT preference. The idea of an independent collateral management system seemed challenging to be implemented, taking into account the data flow. This data flow is created when front-office/front-desk personnel conduct trades/deals/transactions, which are then consolidated into a central position keeping system. This central location is the source of all exposures, but comes with its own complexity. The changing data structure and workflow of the position keeping system only add to this complexity. To outsource the process of collateral management would require a steady stream of positional data to the external information system, which is both labour-intensive and commercially sensitive. The end result is that the FinTech appears to have since been shut down.
This experiment is focused on creating a platform that would assist smaller regional banks and buy-side institutions in managing the collateral put up to counterparties for their derivatives portfolios.
A derivative is a type of financial product whose value is based on an underlying asset, or specific terms. Initially, derivatives were devised to act as a form of protection against movements in a portfolio's value, similar to insurance. Consequently, the amount of the derivative trade is usually larger than the premium paid, in much the same way that an individual would typically pay a premium of S$300–S$500 per year for a term life insurance policy worth up to S$1 million.
Derivative trade is a zero-sum game, meaning what one party gains is the other's loss. This type of trade can remain open for an extended period of time, such as six to twelve months. During this span, the leverage applied may cause derivative value to fluctuate more intensely than its corresponding asset. The result is the need for ongoing settlements in which the party at a disadvantage must pay the other. This series of processes presents inefficiency.
In order to address inefficiency in this market, it has become practice to require both parties of a derivative trade to put forward some collateral to one another, held by a reliable central counterparty. This collateral acts as an on-site temporary settlement within a certain limit and will only prompt an operational settlement to occur if that limit is exceeded.
For instance, in the case of a S$10m trade, the two parties may agree to secure collateral with a value of S$500k. If the fluctuation in the value of the collateral is kept below this figure, then it is accepted that the collateral can be liquidated should it be necessary to close the derivative. This agreement reduces the need for transactional settlements to be made between the two parties. Should the variation exceed S$500k, then the party in deficit will need to submit supplementary collateral.
The procedure of building up collateral consists of (1) ascertaining available collateral; (2) calculating the collateral demand for different derivative trades; (3) keeping track of the site where it is put up as security; and (4) determining the present market value of position and collateral.
It can be difficult for any financial institution to go through this process, and for smaller financial institutions it is especially trying since they don't have the financial or personnel capacity to construct, manage and run the data system required for collateral service. A lot of them were depending on human assessment when it comes to deciding which assets are eligible for collateral and manual practices for the operation.
Apart from running their business, smaller financial institutions typically have to provide extra collateral for their derivative position due to having to base their valuations on the custodians' estimates which normally involve caution. Additionally, they cannot work out the parts of collateral they are able to gain from inverse derivatives that can balance the risk of two separate derivative trades, which would be done to guard against two distinct risks.
The FinTech partnered with a FI with the purpose of constructing a cloud-based collateral management system with a predetermined workflow to handle all aspects of the collateral management process, while at the same time providing a derivative pricing library to give smaller financial institutions self-determination of collateral value. Furthermore, it was set out to decrease market data fees with a bulk subscription to market data access which was incorporated into the collateral management system.
In order to contribute to the environment, the FinTech organization proposed to collaborate with the close-by college to give students the chance to gain practical experience in the industry, for instance, challenging them to work out true-to-life sector issues.
If the experiment turns out positively, it could give rise to a brand-new collateral management product available to Singapore's FinTech industry with the ability to make collateral management more efficient.
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