It has been one of the slowest but most significant changes in central banks' use of over-the-counter derivatives in recent years. As dealers have faced rising funding and capital charges as a result of new regulation, a historical exemption for central banks from the posting of collateral has become a point of contention, pushing up the cost of trading derivatives.
A small number of central bank and sovereign derivatives users have recognised that one-way posting of collateral – by the dealer, but not the client – no longer makes economic sense. The Bank of England (BoE) announced it would start posting collateral in 2012, and the Bank of Canada began its preparations in 2015, while debt offices in a number of other countries, including Denmark, Germany, Portugal and Sweden, are also making the switch.
The two-way posting of collateral does ease the funding burden on derivatives trades for dealers, which should result in sovereign customers receiving tighter pricing. Nonetheless, the switch to two-way collateral agreements has proven to be slow. In part, this is due to central banks clinging to a long-held privilege that they do not want to give up. It is also because posting collateral to counterparties for the first time represents an operational upheaval that requires the repapering of credit support annexes (CSAs) as well as the implementation of new systems and processes.
"Having never previously had to deal with outgoing collateral, our existing technology was not built to manage it, and we chose to use a collateral manager and custodian to manage the posting and receiving of collateral," says David Senger, assistant director in the financial markets department at the Bank of Canada.
"This created an additional challenge in collecting, synchronising and reconciling information with our own internal databases."
In 2015, Canada's Department of Finance contracted State Street Corporation to act as collateral manager and custodian for the government's currency swap programme, but the Bank of Canada needed further technological support to enable the two-way exchange of collateral and the synchronisation of data between its own systems and the external collateral manager.
The central bank was fortunate in that it already had a long-standing relationship with US-based OpenLink and had been using the technology provider's Findur platform for portfolio management and internal record-keeping since 2003. Given its foreign portfolio was already in Findur, it made sense to use the vendor's collateral management services, and this became a major project for both entities over the past two years.
In the first phase of the project, which was delivered in late 2015 and completed user acceptance testing in early 2016, OpenLink used its Trade Process Manager (TPM) tool to build automated processes and reporting systems that would collect relevant information on trades, margin movements and cash transfers to be squared with the central bank's own records.
The challenge in this project was the sheer complexity of the requirements… We spent a lot of time creating complex code for the huge range of collateral scenarios [the Bank of Canada] might face
Philip Wang, OpenLink
While the first phase delivered the core functionality that would allow the Bank of Canada to move to two-way CSAs, the second phase focused on streamlining workflow and bringing greater automation and efficiency to the synchronisation of data between systems. Expanding the use of the TPM module during the second phase to build new workflow definitions and automate the processing of files, OpenLink has smoothed the central bank's transition to two-way collateral posting.
"The challenge in this project was the sheer complexity of the requirements," says Philip Wang, senior vice-president of enterprise strategy at OpenLink. "The industry is still at the very start of the transition to two-way CSAs, so there weren't many existing implementations to draw on. We spent a lot of time creating complex code for the huge range of collateral scenarios the central bank might face."
As the second phase of the project only completed at the end of 2016, the full economic impact of the transition to two-way CSAs cannot yet be quantified, but the Bank of Canada estimates that once fully implemented, the new policy will reduce the government's funding costs by $25 million–30 million a year. By December 2015, agreements has been put in place with counterparties representing 85% of the swap portfolio, reducing government expenses by $93 million, according to the central bank's annual report.
Expanding the toolkit
For OpenLink, collateral management is the latest addition to a toolkit that has steadily expanded over the years and is now used by central banks in 13 countries, as well as a number of state financing agencies with similar requirements. With a diverse client base that spans energy, commodities and financial services, OpenLink has been growing in the central bank segment by roughly 10% each year.
In addition to the Bank of Canada, other major central banks that have tapped OpenLink's technology over the years include the Bank for International Settlements, the BoE, the Reserve Bank of New Zealand, the Reserve Bank of Australia and the Bank of Mexico.
The vendor's Findur system has existed for 20 years and has been developed to manage all aspects of a central bank's operations, including foreign reserves management, liability transactions and treasury operations, with a broad asset class coverage and range of functionality covering the front, middle and back offices.
"Central banks tend to trade fairly traditional products and have conservative views about risk and technology – most are not yet comfortable with cloud-based systems, for example," says Wang. "We have developed a deep understanding of this sector over 20 years and retained a very strong on-premises model, which gives clients valuable control over their own environment and the ability to manage their own upgrades."
The challenging environment in which central banks now operate, with unpredictable macroeconomic conditions and complex structural changes within markets, could play to OpenLink's strengths in the future, as institutions review their infrastructure and consider new technology. Two-way posting of collateral is a clear example of the kind of transition many central banks are going through, and two other OpenLink's clients are understood to also be moving to two-way CSAs.
"There has been a general trend in recent years where specialised trading and risk management vendors like OpenLink have taken market share from corporate treasury system providers. The changing risk and operational requirements of most central banks are pushing the boundaries of what a standard treasury system can provide," says Wang.
Given the more conservative nature of their operations, central banks sometimes find themselves at the back of the queue, behind more commercial entities, when it comes to gaining technical support from their technology providers, but Wang believes this to be a key point of differentiation for OpenLink.
"We operate a very democratic support system that guarantees the same turnaround times for responses to small and large clients, and we have a strong Findur user group that meets on an annual basis. This gives our central bank clients a collective voice and helps to guide where we focus in terms of product development, training and documentation," he says.