What next for collateral management?

What next for collateral management?

Driven by regulatory changes, collateral management is becoming a complex, costly exercise with higher volumes of 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, assessing its availability and the systems and process used to support the collateral management function.

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.

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 OTC business are undergoing significant changes, plus each regulation has its own definition on how customers should be protected.

For example, the Dodd-Frank Act allows for legally segregated but operationally commingled (LSOC) whereas Emir requires providing the customer options between omnibus accounts and individual segregation. 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. According to economists at the International Monetary Fund (IMF), 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 cross asset netting are still in development as technical standards have not been finalised 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.

4)      Collateral Optimization

The “optimisation” 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, optimisation can also mean generating increased revenue by offering collateral funding and transformation services.

In order to achieve optimisation, 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.

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 who can source high quality collateral and deliver it to clients who need it.

Looking to the future

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. For example, 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 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.

At the same time collateral management is shifting from its traditional back-office location and towards the middle and front office. To manage changing collateral requirements and improve efficiency will require significant improvements to processes such as dispute management and communication, and reducing costs by implementing collateral optimisation strategies.