Collateral Damage: Regulatory Fallout Is Transforming Collateral Management

By Thomas Schiebe and Neil Wright, Sapient Global Market

Originally published on TABB Forum 

Regulatory reform has transformed collateral management into a complex, costly exercise involving higher volumes of collateral, increased margin calls, and interaction with more counterparties. But while fewer than half of market participants feel strongly that their institutions have efficient processes for collateral management, there are opportunities for quick wins. 

New legislation around the globe – including Dodd-Frank, EMIR, and Basel III – has created a tangled web of rules designed to increase market stability and resiliency, enhance transparency and accountability, and reduce counterparty, operational, and liquidity risk. The fallout of regulatory reform for most banks and capital market participants has transformed collateral management into a complex, costly exercise involving higher volumes of collateral, increased margin calls, and interaction with more counterparties.

A recent Sapient Global Markets survey examined some of the key issues for firms, including collateral availability, strategies, dispute management, and the systems and process used to support the collateral management function.

That survey revealed that 95% of respondents expect the amount of OTC clients with collateral agreements to increase, as well as the amount of daily collateral calls. Additionally, more than half expect disputes to significantly increase as a result of new participants in the collateral space.

With such a significant evolution of the market underway, these results are unsurprising. Many market participants have cobbled together fragmented systems, manual processes, and siloed approaches for collateral management in order to ensure compliance with various regulatory requirements. Unfortunately, such efforts have made managing and processing collateral a very inefficient and costly component of their businesses. In fact, fewer than half (45%) of participants in that survey felt strongly that their institutions have efficient processes for collateral management, particularly in the area of communication and dispute management.

While regulatory change continues to drive firms’ investments in new technology and infrastructure, there are also a number of trends influencing the desire to increase efficiency and reduce costs, the most prominent of which we’ll discuss in further detail below.

Shortfalls 

At the same time that demand for collateral has increased, circulation of existing collateral has decreased. 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.

Technology and efficient processes play a critical part in steering clear of shortfalls.

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

Collateral Optimization 

When it comes to collateral management, it seems that everyone is striving to achieve optimization. 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.

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. The 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.

Given the revenue potential, more than half (66%) of custodians surveyed intend to offer or already have a partial transformation service.

How to achieve greater efficiency 

While traditionally, collateral management has been an administrative, back-office function set up as a cost center, the business model is changing dramatically, driven by new regulations and cost pressures. As a result, market participants are currently 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. Successful execution requires solid planning, advanced technology, and improved processes.

To realize quick wins and be highly effective in reorganization, reprocessing and reengineering, firms should focus on six key areas: inventory management, risk management, data management, reporting and analysis, dispute management, and communication standards.

These six elements, alongside the various challenges to implementing collateral management systems, are discussed in further detail in a Sapient Global Markets white paper, available to download here.