Going electronic

Collateral management functions currently exchange margin call notices and confirmation of interest payment by email, but the need for automation is becoming more urgent. The industry is looking to define the sequence of messages that would need to be exchanged to allow the electronic communication of margin calls, but how long will it take for the vendors to develop a solution? By Clive Davidson

As part of its effort to improve efficiency in collateral management processes, the derivatives industry has identified the need to automate the exchange of messages relating to margin calls, confirmations of interest settlements and requests for collateral substitutions. This will entail replacing current email, telephone and fax communications with electronic messaging.

While there is general agreement this will improve the efficiency, reliability and security of communication, it raises a number of issues - for instance, what should the electronic messages contain, who will provide the mechanism to exchange the messages, and how long will it take for technology and messaging service vendors to create automated solutions? A number of initiatives are under way that seek to answer these questions. And as with many such automation initiatives, it is forcing the industry to clarify and form a consensus around what is best practice.

In a letter to the Federal Reserve Bank of New York on June 2, the major dealers in the over-the-counter derivatives market, under the auspices of the International Swaps and Derivatives Association, committed themselves to delivering a proposal for defining a sequence of messages to be exchanged electronically for margin calls, interest payments and collateral substitutions, and to define the attributes of the messages, as well as their optimal timing and frequency. Part of a 'road map for collateral management' drawn up by the Isda collateral committee, the proposal aims to facilitate the exchange of such messages "in an open standard that allows for interoperability between existing platforms". A draft of the proposal was planned for the end of July, with the final version to be published by October 31, 2009 (Risk July 2009, pages 62-641). However, the committee added the rider: "Although we commit to establishing this proposal by the dates specified, implementation dates are largely dependent on technology and vendor deliverables."

At the moment, market participants make margin calls and exchange information about interest settlements and collateral substitutions using a combination of emails, telephone and fax. This system is open to operational risks - emails are not necessarily secure, there is no guarantee of delivery of the messages, no audit trail, and no controls on the timing of messages. And because the information is often conveyed in an attached document, those preparing the messages are sometimes distracted by concerns with logos, font sizes and disclaimers instead of focusing on the content.

Despite weaknesses in the current system, industry participants claim it works reasonably well. However, a combination of regulatory pressure to improve all aspects of OTC derivatives trade processing and the evolution of technology, which now offers methods of communication that will address the frailties, has persuaded the industry to upgrade the messaging process. In truth, the largely manual and ad hoc information exchange process for margin, collateral and interest settlement is something of an anomaly in an environment where most major market participants use sophisticated high-performance technology with many automated processes for managing their collateral. These systems are either developed in-house or acquired from specialist vendors such as Toronto-based Algorithmics, London-based Lombard Risk or Massachusetts-based AcadiaSoft.

"In the past 10 years, there has been a lot of investment in technology to work within firms to help manage their collateral, but very little invested in technology to sit between firms and make the process of margin calls more efficient," says Michael Clarke, global head of collateral management and client valuations at UBS in New York and co-chair of the Isda collateral committee.

The first step in developing electronic messaging for collateral management is to define the messages that participants will exchange. While this might seem straightforward, as the industry has been exchanging this information by other means for many years, it turns out that, at least for margin calls, the old method of email, phone and fax allowed for considerable negotiation as to exactly what information was swapped. In contrast, automation requires clarity and standardisation, meaning the industry has to come to an agreement as to the precise content of the messages.

The essence of a margin call message, apart from the identification of the sender and addressee, is a statement of the margin call amount. Some believe that should be all the message contains, at least initially. The recipient will then respond with a message to say they agree or disagree. If the recipient agrees, they send the amount, and the process is complete. The problems arise when there is disagreement. If Bank A sends a message to Bank B with a margin call for $10, but Bank B calculates it should pay $12, what should happen? Should the messages require Bank B to own up and say it calculated a greater margin amount? Some say the initial set of messages should contain additional information that could potentially resolve the disagreement and avoid a dispute procedure - for example, information about the exposure, collateral balance and a tolerance level for accepting discrepancies. Others say providing information beyond the simple margin amount could give too much away to the counterparty unnecessarily.

"If a standard message requires a lot of detail, there is a danger it can lead to market participants inadvertently exposing information they may not have done if they were having a phone conversation or just reacting rather than proactively responding," says David Wechter, senior director of collateral product management at Algorithmics.

At present, there is no consensus over how much detail the messages should contain. "Everyone has a different take on how the process works best. The Isda collateral committee's role is to help find a consensus," says Mark Higgins, head of sales and marketing for global collateral management in Europe, Middle East and Africa at The Bank of New York Mellon.

Many in the industry believe adopting a methodology that masks discrepancies in margin calculations is counter-productive and could create trouble further down the line when trying to reconcile portfolios. They argue it is inappropriate in an era of transparency, where there is a growing use of daily portfolio reconciliation services, such as those provided by Stockholm-based TriOptima and London-based Markit. On the other hand, the fact portfolio reconciliation requires counterparties to submit key information about portfolios on a regular (increasingly daily) basis means the margin messages between participants may only need minimal information.

"As we get more take-up of portfolio reconciliation services, I suspect a margin call message can become pretty brief because participants will have identified the deal, its parameters and its valuation in the reconciliation process," says Julian Day, head of trading infrastructure at Isda. However, where counterparties are not using portfolio reconciliation services, the message would have to be more detailed.

Once the industry has defined a set of standard messages, the next question is how will they be delivered? Market participants will generate the messages via their collateral management systems that currently calculate margin and manage the collateral exchange and reconciliation process. (In smaller organisations, especially on the buy side, this might be done with spreadsheets.) The new element would be the infrastructure to carry the messages between the participants' systems. So far, there are three potential candidate infrastructures, and more may enter the ring.

AcadiaSoft, whose existing collateral management platform is focused on the buy side, is working with a number of major market participants, including Credit Suisse, Goldman Sachs and Chicago-based hedge fund Citadel Investment Group, on a new message exchange platform. According to Craig Welch, co-chief executive of AcadiaSoft, a number of dealers have been testing the pilot technology by running it in parallel with their existing collateral communications arrangements.

Another candidate is Algorithmics, which announced in July it is developing a collateral management message exchange platform. The company has 70 users of its Algo Collateral Management system, including HSBC and Standard Chartered Bank, and has drawn upon parts of this client base and others in the industry to create an advisory panel for the design of its exchange platform. Meanwhile, La Hulpe, Belgium-based banking communications network provider and standards organisation Swift is looking to upgrade the collateral management messaging it already offers on its network. It will implement new standard messages once the industry agrees them, and develop additional software for "orchestrating the exchange of messages between the collateral management players", says Michel Keulemans, head of pre-settlement programmes at Swift.

Although it is technically feasible a single message exchange platform could manage the task, the industry generally welcomes the fact there are various potential solution providers. "I would be surprised if there were not a number of providers interested in building an electronic message exchange platform," says Day of Isda. "While having myriad providers is not good because it disperses volume and critical mass, equally there are disadvantages to having just one provider."

Clarke of UBS agrees: "The benefits of a central (electronic message exchange platform) are that you instantly get both standardisation and a technology solution, and if everybody uses the same platform you get a very high degree of coherence. The downsides are it is a single point of failure, you are reliant on one vendor, and there can be a lack of innovation because of the monopoly supplier."

Vendors should be encouraged to go ahead and develop prototype platforms, but must ensure they will be interoperable, Clarke says - in other words, be able to technically link and communicate with one another and exchange the standard messages. "From a dealer perspective, we want vendors to invent platforms that meet the requirements, agree how to interoperate with one another, and then provide to both dealers and the buy side a range of options, but with the assurance the platforms will all interoperate," he adds.

Interoperability is an issue that has sunk many previous standards initiatives. In the June letter, the Isda collateral committee states its proposal will define the sequence of messages for margin calls, interest settlements and collateral substitutions, as well as the message attributes and their optimal frequency and timing. This appears to be quite specific, but defining a standard is generally the easy part - it is the implementation that is the challenge. Standards can often be interpreted in different ways when they are embedded into computer systems, and this can lead to incompatibilities between vendor platforms. The financial industry has learnt from considerable wasted time, effort and money to be wary of technology standards and central infrastructure projects, hence the demand for guaranteed interoperability between vendor systems.

However, market participants need to look at the issue of interoperability more broadly - and not simply ensure a collateral management system can commmunicate with a message exchange platform and vice versa, warns John Wisbey, chairman and chief executive of Lombard Risk. In particular, the perfomance of dealer management systems could be compromised if the message exchange is poorly implemented. "If you are a major dealer and you have 20,000 or more collateral agreements, you care if it takes half an hour rather than half a day to process them. So you have to think carefully before you put something into the process that is going to slow the whole operation down," he says.

Lombard has 40 clients for its Colline system, including Northern Trust and Fortis. The Bank of New York Mellon uses Colline as the underlying technology for its DM Edge collateral management service for the buy side and its recently announced Derivatives Collateral Net netting service for dealers. Although Lombard has not ruled out building its own electronic messaging platform, Wisbey says that, for the moment, the company is looking to work with the other services that are coming into the market, including Swift - a platform he believes is well positioned as so many participants in the market already use its messaging services for other purposes.

Achieving critical mass is an essential factor in efforts to develop standards. Many technically proficient standards have failed to gain traction in the market, either because of inertia, opposition by vested interests, a lack of a compelling business case for their adoption, or other reasons. In fact, Swift has offered collateral messages on its network for some time, and although those for triparty collateral agent services are frequently used, there has been little take up of its bilateral messages.

Algorithmics and AcadiaSoft both intend to provide an interface for in-house or third-party collateral systems to interoperate directly with their messaging platforms, but will also provide a web portal and browser interface for those using less sophisticated applications or spreadsheets to send and receive messages. Swift already has these kinds of facilities on its network. The aim is to make the platforms widely accessible to hedge funds and other smaller, less technologically equipped organisations, and thereby achieve the critical mass that will be necessary for success.

"Critical mass is of essence because an industry electronic messaging solution has to be a business proposition," says Wechter of Algorithmics. "The concern is not so much for tier-one sell- or buy-side firms, but for tier-two and three firms getting involved so there is a comprehensive change in how collateral as a business is run."

Other features any successful message exchange platform will have to demonstrate is global 24-hour operation, reliability, security and ease of connection. There are many examples of this sort of technology in the market already - and Swift, for one, already operates a network with these attributes.

With a number of other initiatives under way in the collateral management space - for instance, agreeing best practice for dispute resolution and moving to daily portfolio reconciliation - dealers admit automating margin calls, confirmation of interest settlements and requests for collateral substitutions is not top of their agenda. Nevertheless, in its June letter to the Federal Reserve Bank of New York, the Isda collateral committee committed itself to a first draft of a proposal for electronic messaging by the end of July, with a final version by October 31. As Risk went to press, the content of the draft proposal was still vague. However, Clarke anticipates it will set out a general description of the standards and best practice around their implementation, including statements about interoperability.

"Many people have been using the term interoperability and stressing its importance. But without a more explicit specification of what we expect this to be in terms of electronic messaging, it is a bit hard for vendors to know what the expectations of the industry are or what to build," he notes. "We need to work together across dealers, buy-side firms and vendor partners to address that."

Given the plethora of industry initiatives and regulatory requirements in the wake of the financial crisis, electronic messaging for collateral management has to find a place in the queue for bank resources. Nonetheless, the industry has committed itself to conducting the groundwork of defining standard messages and interoperability requirements, and vendors believe there are business opportunities for them in meeting the need for electronic messaging. Given these sentiments, it will be a matter of seeing which solution, or set of solutions, the industry favours.

The outcome of such processes is rarely predictable, and there is no guarantee of success. However, there has been a steady effort to automate the collateral process to reduce operational risk, by minimising inefficient and error-prone manual interventions and employing straight-through processing. Automated messaging and workflow is integral to realising such straight-through processing, and the current initiative to create messaging standards is part of this larger automation effort. It is only a matter of time before the industry achieves it.