Mandatory clearing of OTC derivatives transactions has dealers and swap participants scrambling to marshal their assets to meet collateral obligations, a process known as “collateral transformation.”

Swap dealers, major swap participants and private funds active in the swaps market have all been required, from March 11, to begin clearing certain index credit default swaps and interest rate swaps.

All other financial entities will be required to clear swaps beginning on June 10, 2013, for swaps entered into on or after that date. Buy-side market participants transacting swaps must determine whether they are subject to the mandatory clearing requirement.

As the implementation deadline looms for mandated clearing of OTC derivatives contracts through recognized Central Counterparties (CCPs), the continued debate around collateral transformation remains firmly centered on the decision to be a provider (transform) or a consumer (be transformed) of collateral transformation services, according to Minling Chen, senior manager at Baringa Partners.

“This decision is by no means a straight forward one,” Chen said in a blog posting. “There are many factors that need to be considered as part of this, including the operational complexities, the cost versus benefits of providing the service (as opposed to consuming the service) and the resulting implications on balance sheet usage and risk management.”

Collateral transformation “is really a form of collateral optimization – which is making sure that collateral is allocated as efficiently as possible, and the process will include swapping bad collateral for good collateral,” said Scott Skyrm, a former head of money markets and repo for Newedge, in a blog.

If properly optimized, the lowest acceptable grade collateral is pledged, working from worse to best. This year alone, Citibank estimates $100 billion in collateral will need transformation due to mandatory swaps clearing, according to Skrym.

The potential costs associated with the funding of collateral transformation services cannot be under-estimated.

In the current capital constrained environment, market participants are continually assessing the use of their balance sheet and ensuring that their limited capital is used to generate the best yield/return. “One of the operational challenges is to centrally manage the usage of balance sheets across different businesses, and to be able to ‘charge back’ the cost of balance sheet usage to the respective business line,” Chen said. “Conversely, it is also key to have the ability to allocate the use of the balance sheet to generate the highest return i.e. balance sheet optimization.”

To become a provider of collateral transformation services, the organization will need to maintain an intraday consolidated view of the utilization of collateral and where it is located, across the different product lines.

“A more siloed organization is likely to face a greater scale of change in order to harmonize existing processes and systems to provide a single view of collateral inventory across the organization,” Chen said.

For market participants who are weighing up the amount of investment required, they should also consider the use of an outsourced provider to provide tracking and visibility of collateral usage, as opposed to managing it in-house.

Many of the big custodian banks such as State Street and Bank of New York Mellon are currently looking at providing collateral transformation services, alongside their custodial collateral management offering.