For a subject that has been around the industry for a long time, collateral management is enjoying a sustained period of popularity. Global regulations, such as the Dodd-Frank Act from the US and the European Market Infrastructure Regulation (EMIR), are radically changing the requirements for clearing and collateral, promoting the central clearing of standardised OTC derivatives contracts, as well as new margin requirements for OTC contracts that continue to be non-centrally cleared.
These rules will push trades towards central counterparty clearing houses (CCPs), and have the potential to transform collateral management into a potentially complex, costly exercise involving higher volumes of collateral, increased margin calls and interaction with both bilateral counterparties and CCPs.
Investor service providers are working intensively on building new and more tightly integrated solutions to meet clients’ changing needs, says Emmanuelle Choukroun, director at Société Générale Securities Services.
She argues that while many will have a role to play in the collateral management chain, established custodians are indisputably the institutions most likely to be relied upon to guide clients through what could prove an awkward transition period.
“Custodians are best placed to have a view of client inventories across various locations, because that is our core business,” she states. The eventual winners will be those that offer all these services in a way that meets client needs most efficiently and cost-effectively.
She lists five essential components of service provision in the new-look collateral management landscape.
First, derivatives and repo position keeping – the exposure at risk for which collateral is needed.
Second, collateral administration – the system that provides support when determining the margin calls to be exchanged with counterparties.
Third, collateral-tracking infrastructure to map the collateral assets received by clients as well as the collateral assets posted to their various counterparties.
Fourth, collateral optimisation – the tool that helps minimise allocated collateral, taking into account haircut levels and regulatory constraints. And fifth, collateral sourcing – for those occasions when it is not possible to optimise the pool of assets available for collateral, or when clients lack eligible collateral.
Similarly, in a recently published paper – ‘Bringing Efficiency to Collateral Management’ – Sapient Global Markets, a provider of business technology and consulting services, pulls together a number of the sector’s most current themes. The paper, examining collateral management trends and their effect on systems and processes, discusses how and where firms must deliver greater efficiency in order to remain competitive and protect revenues.
At a glance
• Regulation that changes derivative-clearing requirements could be about to make collateral management much more complex.
• To increase operational efficiency, there is a need to consolidate the collateral management function across all asset types that are subject to collateral or margin – custody banks’ silo approach has arguably led to a lag in this development.
• However, the widely-expected ‘global collateral shortfall’ that would press this agenda is, so far, conspicuous by its absence, as demand has remained muted and new supply has come to market.
• This raises questions about the need for ever more complex solutions to collateral management problems that, so far, do not seem to exist, but also the new risks these solutions introduce.
There are several lessons to be learnt from the survey that underpins the paper, says Gordon McDermid, director in business consultancy at Sapient Global Markets. “One, we are seeing an evolution in collateral management from a cost centre to a profit centre and situated towards the front office rather than hidden away as a back office function,” he says.
“Two, there is a trend to deliver increased automation with the aim of realising greater efficiencies.
“Three, we’re seeing increased outsourcing by the buy-side as the systems required to support it need to be thoroughly understood and better implemented into an institution’s infrastructure. If pushed to summarise the issues in one sentence, I’d say the collateral world is undergoing a period of significant change and is becoming far more dynamic and proactive than in the past.”
However, banks that have become used to coming up with tactical solutions haven’t thought fully about efficiency, adds Sapient Global Markets, senior associate Thomas Schiebe.
“They need to overcome the traditional silo approach and bring the derivatives side of their business together with their securities-based lending, financing and repo business,” Schiebe explains. “Market participants have patched together fragmented systems, manual processes, and siloed approaches to ensure compliance with various regulatory requirements. Unfortunately, such disjointed efforts have made managing and processing collateral inefficient and costly, which impacts profitability.”
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.
The white paper identifies and discusses six key areas for improvement: inventory management; risk management; data management; reporting and analysis; dispute management; and communication standards.
The success of custodians in providing securities services in general, and collateral management services in particular, has traditionally been predicated upon their having a large number of clients with high volumes of assets in a single pool, enabling the standardisation of operational models and achieving economies of scale. But as demand grows from managers for the segregation of their assets some traditional providers could find themselves less well placed than others.
As a result, this often misunderstood corner of the international financial services industry seems to be experiencing one of its periodic bouts of reshaping.
“In three to five years, it will look very different,” predicts Simon Lee, managing director at eSecLending. “To have an efficient collateral transformation and optimisation process, the silo barriers between different products must come down. We are all at a different stage but every organisation knows it has to do it to be efficient. If they don’t, they increase costs and don’t maximise revenues. The bigger the firm, the more complex and more difficult the reshaping process will be.”
But just how “significant” is this change really going to be? While the new-look collateral transformation market is very much the centre of attention, the predicted upsurge in activity has, so far, failed to emerge. The new clearing environment – combined with the impact of new liquidity requirements under Basel III – was widely expected to increase the demand for assets suitable for use as collateral, particularly high-quality liquid assets. What we have seen, instead, is one of the biggest anti-climaxes in financial history. The predictions that there would not be enough collateral to meet the new demands being placed upon the industry will not, it seems, be coming true.
So how and why has the industry been proved so wrong so far? Put simply, demand for quality collateral has been lower than expected, while supply has been higher.
On the demand side, the loosening of the Basel III liquidity coverage ratios helped, by reducing the amount of collateral that banks are required to hold as reserves over a 30-day period. The recommendations of the International Organization of Securities Commissions (IOSCO) on the level of initial margin calculations for non-cleared swaps have also played a part, as has the decision to phase in the new requirements over a multi-year period.
On the supply side, new high-quality collateral assets have reached markets from a variety of sources. And institutions are expanding the range of collateral that they will accept. The Chicago Metal Exchange, for instance, now allows the use of corporate bonds as collateral to cover derivatives exposure.
Euroclear director and product specialist Olivier de Schaetzen observes that the additional collateral requirements predicted by institutions such as the IMF and Bank of England when new regulations were announced have not yet been translated into a spike in the usage of collateral management platforms.
“We can see from the activity taking place on our collateral management platform that there has been a gradual inflow of new business with the migration to central clearing of derivatives contracts – but no huge boom as predicted,” he says. “The increasing business is a clear translation of regulatory impacts into everyday practice but not to the degree first expected. We are seeing evolution taking place in the market as collateral management becomes critical to many businesses’ profitability and safety, but not the envisaged revolution – so far.”
Average daily outstandings on Euroclear’s Collateral Highway platform reached €833bn at the end of May 2014, up 6% from the start of the year.
While that is modest growth – and, as Choukroun points out, Euroclear’s Collateral Highway and similar platforms are estimated by independent think tank Eurofi to account for only around 15% of total market activity – it is growth nonetheless, and it is accompanied by gradually evolving practices.
One particularly interesting development De Schaetzen identifies is the growth of buy-side activity in collateral management. Capital market participants, typically buy-side firms that have traditionally been takers of collateral, have now also become securities collateral givers, mobilising long assets to meet their margin obligations for their derivative activity such as interest rate swaps.
Collateral growth at Euroclear is organic, rather than explosive, De Schaetzen explains, as other non-traditional firms have joined the tri-party market. These include cash-rich corporates seeking to remove banking risk by insisting on secured lending to banks rather than unsecured, in effect converting ‘depo(sit)’ into ‘repo’.
Another area of growth comes from the community of central banks that are increasingly using Euroclear’s tri-party collateral management platform to conduct their open-market operations, he continues.
“Collateral management, transformation and optimisation is a product that must be tailored to the precise needs of each individual client,” says De Schaetzen.
Lee at eSecLending, also highlights the issue. “One product doesn’t fit all,” he says. “Different fund managers with different funds pursuing different investment strategies will all have different needs; once clients tell us what they are looking for, we can tell them whether or not we can help.”
But the creation and provision of overly complex customised algorithm-based ‘solutions’ to investors is, in itself, problematic, says De Schaetzen.
“Ignoring, for the present, that they are often devised to tackle a problem that we have seen does not in fact exist, there are clear practical, customer relationship and commercial issues involved,” he explains. “Few institutions, for instance, will be capable of providing the dedicated support team with the deep domain knowledge required to assist clients when things go wrong with quantitative ‘solutions’. We see little merit in selling unnecessarily complex and overly expensive services to clients without delivering associated sophisticated support.”
In this context, clients clearly risk increasing their overall costs rather than reducing them, for no additional benefit.
The variations in collateral management are almost literally endless, limited only by the imagination of traders and the capacity of the underlying systems. One example, cited by Markit managing director David Carruthers, is a typical stock-loan transaction, a so-called ‘collateral upgrade’ trade.
Imagine a pension fund holding its assets, including a large number of Gilts, with a custodian; and an investment bank market maker holding an inventory of coporate bonds. The investment bank phones the custodian and asks if it has any Gilts it can borrow, in return for some of its high-quality corporate bonds. On behalf of the pension fund, the custodian lends the Gilts to the investment bank, taking the corporate bonds as collateral.
The pension fund enjoys a lending fee on top of the Gilt running yield; the custodian gets a small percentage of that fee; and the investment bank now has some Gilts that it can repo out for cash (to meet short-term obligations or fund its own risk-taking) at a lower rate than if it were forced to post the original corporates as collateral. If the Gilt repo rate plus the stock loan fee is lower than the corporate-bond repo rate, this is a good trade for the investment bank. In short, everyone is happy.
A collateral transformation swap (CTS) is simply the set of transactions described above in one wrapper, provided by the custodian for a fee that is, of course, higher than the fee the custody bank is paying for all of the components. Is the price of such a collateral transformation swap worth paying, or even justifiable, in the eyes of the borrower?
Securities-lending consultant Finadium, in a July 2014 industry survey, found demand for the collateral transformation trade and spreads over an equivalent ‘regular’ securities loan at only five basis points in benefit to the lender – suggesting that, on balance, the fees must be acceptable. Indeed, borrowers often said that they would not do a trade at all unless it fell into this collateral-transformation category because, otherwise, it would be too expensive from a capital charge perspective.
A lot depends on the extent to which pressure grows on the high-quality collateral supply-and-demand dynamic as central clearing beds in, and the regulatory environment in which different counterparties to collateral transformation trades operate. At this stage, the complex products and processes being developed seem like a solution in search of a problem but there is enough activity already to suggest that there would be significant risk attached to betting on the status quo.
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