5 Trends Transforming Collateral Management

By Thomas Schiebe, Sapient Global Markets

Originally published on TABB Forum

As the costs of central clearing, collateral reporting and margining continue to rise, firms will need to evolve their operating models, architecture and legacy collateral management solutions in order to remain competitive and protect revenues. While driven in part by regulation, there are a number of converging trends influencing the desire to increase efficiency and reduce costs.

Regulatory reform – in the shape of European Market Infrastructure Regulation (EMIR) and the Dodd-Frank Act in the United States, together with upcoming rules from the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) on margin requirements of non-centrally cleared derivatives – is transforming collateral management.

Complexity and cost are both rising due to higher volumes of required collateral, increased margin calls and interaction with more counterparties. With such a significant evolution of the market underway, firms are facing up to the challenge of managing eligible collateral and assessing its availability as well as the systems and processes used to support the collateral management function.

Many market participants have attempted to bring together fragmented systems, manual processes and siloed approaches for collateral management in order to ensure compliance with various regulatory requirements. However, as the costs of central clearing, collateral reporting and margining continue to rise, firms will need to bring efficiency to several areas of their collateral management process in order to remain competitive and protect revenues.

While driven in part by regulation, there are a number of converging trends influencing the desire to increase efficiency and reduce costs.

1. Collateral Segregation

While requirements in the exchange-traded derivatives business are well established, margin requirements in the over-the-counter (OTC) business are undergoing significant changes; plus, each regulation has its own definition of how customers should be protected. For example, the Dodd-Frank Act allows for legally segregated but operationally commingled (LSOC) customer assets, whereas EMIR requires providing the customer options between omnibus accounts and individual segregation. Segregation of cash collateral is a cumbersome process but is required within the new regulatory environment for initial margin requirements. These different requirements need to be implemented and these costs need to be accurately transferred to products and/or business units.

Implementing multiple types of available segregation forms based on client types and products, particularly in the OTC space, may become challenging. Based on the complexity and lack of complete regulatory harmonization across the globe, institutions should begin the necessary impact analyses immediately. The effects on risk, margin, collateral, settlement, processes and systems can be far reaching.

2. Shortfalls

Demand for collateral has increased, yet circulation of existing collateral has decreased, in part due to regulations such as the EMIR implementation of the BCBS/IOSCO proposals that explicitly prohibit the re-use of received collateral. According to economists at the International Monetary Fund, declining confidence in issuers and counterparties has reduced the circulation rate of collateral between counterparties from three times its original value in 2007 to just 2.4 times today. With issuance of highly rated securitized debt also shrinking, predictions of a worldwide collateral shortfall are possible.

This puts greater pressure on firms to identify eligible collateral, locate it and then match it with the collateral demands they face. If they lack the collateral eligible to meet one of those demands, they have to work out how to obtain it. Mismanaging collateral can damage performance and reputations, as well as increase costs.

3. Cross-Asset Netting

Netting on counterparty exposures decreases the amount of collateral a firm must maintain to cover credit risk and protect the balance sheet. Being able to perform pre-trade scenario analysis of counterparty usage and execution can offer significant cost savings to firms.

Unfortunately, tools to perform efficient cross-asset netting are still in development because technical standards have not been finalized by regulators. Once available and adopted by market participants, firms will be able to more easily estimate exposure and the impact of a trade and make cost-effective decisions as to which counterparties through which to trade and clear.

4. Collateral Optimization

As collateral resource management becomes established as a dedicated business line, it has become obvious that optimization is required. The “optimization” of collateral seeks to make the best use of available assets. Using algorithms, applying compression/netting across assets or simple prioritization rules can reduce costs and improve liquidity. For service providers, optimization can also mean generating increased revenue by offering collateral funding and transformation services.

In order to achieve optimization, firms must have sufficient levels of automation and straight-through processing, as well as technology in place to help identify eligible collateral, prioritize its use, and deliver the lowest cost, mutually acceptable form of collateral across an entire firm.

5. Transformation

New regulations now require derivatives market participants to post collateral with counterparties for both cleared and uncleared transactions. This makes it imperative for firms to have systems in place to know exactly what eligible collateral they have available to meet a collateral call—a requirement that could be problematic for some firms. A Sapient Global Markets’ survey revealed that only 51% of market participants have a complete view of their entire inventory of eligible assets to be posted as collateral across business units.

If a firm does not have sufficient, available assets, it can either borrow from a firm through a straight-forward lending agreement, or for a fee, have its lower-grade assets (with significant haircuts applied) transformed into eligible assets. Such transformation services create a new revenue stream for those that can source high-quality collateral and deliver it to clients that need it.

Managing Collateral in an Evolving Market

As the markets continue to transform and adapt to the new regulatory regimes, it will be interesting to see how the collateral management function evolves. We’re already seeing many institutions accepting bonds as non-cash collateral, with an appetite to extend the assets that are considered eligible in order to meet the increased demand for collateral. But differing regulatory definitions of assets that qualify as collateral and specific eligibility criteria set by central counterparties (CCPs), clearing brokers and counterparties in the case of non-cleared trades significantly increase both the complexity of non-cash collateral and also the requirements for collateral management systems.

To date, firms have implemented tactical solutions to meet regulatory mandates in various jurisdictions, but as the regulations solidify, they will need to adapt these tactical efforts and begin implementing strategic solutions. Different segregation models, margin requirements, restrictions on re-hypothecations, bifurcated portfolios with both centrally and non-centrally cleared OTC derivatives, limitations on eligible collateral and increases in liquidity ratios all raise the complexity and costs.

Firms will have to evolve their operating models, architecture and legacy collateral management solutions, which range from simple spreadsheets to more complex systems. Depending on the availability of technology funding and internal expertise, a firm has three options:

Manage In-House with Existing Systems

For firms with their own proprietary collateral management systems, updating those systems may make the most sense, given the level of custom functionality included and compatibility with other internal systems. However, collateral management success will hinge on a firm’s ability to remove siloed approaches and transform their systems into a full-blown collateral management platform. A platform that consolidates the collateral management function across all asset types and provides an entity-wide overview of all available and eligible collateral.

Manage In-House with Vendor Solutions

A vendor software solution can be an ideal option for firms that do not have—or do not wish to spend—the resources to build and maintain in-house systems or want to add features and functionality to their collateral management that go beyond the capabilities of their existing, proprietary systems. Vendor systems are continuous updated to adhere to the latest regulatory requirements and often include usability features, enhancements and new algorithms requested by customers.

Outsource Collateral Management Functions

Depending on a firm’s business model and structure, outsourcing can be an effective option to save on operating and maintenance costs. Outsourcing allows a firm to leverage a third party’s targeted expertise and economies of scale for collateral management functions, such as reconciliation, reporting, liquidity management and dispute management.

Conclusion

Collateral management as it currently is known will no longer exist within a few years. Market participants are already exploring new revenue streams through transformation services, efficiencies with cross-asset netting, bringing improvements to processes such as dispute management and communication, and reducing costs by implementing collateral optimization strategies.

We are already seeing this shift, with some early adopters integrating collateral management within their treasury departments. As an increasing number of firms recognize the opportunities to reduce costs and increase profitability, the evolution from an administrative back-office function to a more front-office, revenue-generating function will accelerate. That, in turn, will have a significant impact on the systems and processes required to support the demand to optimize collateral rather than simply administering or managing this process.