Custodians Gearing Up to Support More Complex Collateral Management Needs of Buy-Side Clients

May 1, 2011

Growing complexity in managing collateral resulting from new CCP collateral requirements and regulatory reform is driving buy-side firms to consider outsourcing the back office function to custodians. DerivSource’s Julia Schieffer speaks to the custodians about how they are enhancing collateral management service offerings to support new needs of clients in a new marketplace.

Collateral management is central to ongoing transformation of the Over-the-Counter (OTC) derivatives marketplace. Faced with central clearing some OTC derivatives and the need to execute more stringent credit counterparty risk mitigation practices, many buy-side firms need to establish more efficient and sophisticated collateral management practices. The new complexities in the marketplace are driving a growing number buy-side firms to seek outsourced solutions.

Collateralization is expected to rise over the next few years as financial institutions pledge more collateral to cover risk exposures for bilateral trades and to meet new central counterparty clearing (CCP) requirements, including the pledging of initial margin. Firms must be equipped to deal with an increase in collateral volumes and the complexities of a new OTC derivatives marketplace following regulatory reform in Europe under the European Market Infrastructure Regulation (EMIR) and under the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) in the U.S.

Greater complexity in the market reinforces the need for buy-side institutions to gain a better handle on the cost and efficiency of collateral management operations, said Sean Sprackling, director at PricewaterhouseCoopers.

“The driver for outsourcing the function has always been that, for most investment managers, collateral management is not a core specialism and it is more cost efficient to outsource it rather than source the skills required and set up the systems and processes in-house,” he said. “In today's environment, with the tsunami of regulation bearing down on them (including Dodd-Frank, EMIR, Solvency II and Capital Requirements Directive) all of which will in some way affect the complexity of the collateral process, this driver is becoming even more pronounced.”

A typical custodian collateral management service includes the movement of a client’s collateral in and out of the market to meet its obligations and to provide the recordkeeping and support services, such as asset valuations, around those activities. 

One of the complications of dealing with both bilateral and CCP volumes is the correspondence with a greater number of counterparties and the need to get a better handle on the collateral inventory across the firm. 

Financial institutions need a fuller, deeper and more real-time view of collateral and its movements, said Patrick Centanni, executive vice president and head of Global Product Management at State Street.

State Street launched a collateral tracking service to enable clients to monitor collateral across multiple counterparties to accurately assess and manage counterparty risk. Users of the service send the collateral instructions to the collateral tracking hub, which automatically initiates the process of tracking the status and location of outstanding collateral. The service also provides customizable reports to users.

“The problems of the last couple of years have taught financial entities, particularly asset owners but also asset managers, that they need a deeper, more timely tracking and recordkeeping solution so they can better understand where the collateral is, when it will arrive, how it is valued, and monitor other types of activities, such as income collection, that are taking place,” said Centanni. “Clients also want more information on exposures and real-time reporting to help facilitate the effective management of collateral.”

Custodians already provide the management of collateral in and out of the market and to various counterparties, but State Street’s collateral tracking service gives a client many of the more sophisticated virtues of a full collateral management service without the price tag of an in-house operation, Centanni added. 

The ability to track and monitor collateral activity also sets up the foundation for other added-valued services such as netting and collateral optimization. 

JP Morgan offers a cross-margining capability to its clients by amalgamating the margin calls across geographies, business lines (both bilateral and CCP trades) to provide the client with a single net exposure so the client does not have to deal with multiple margin calls from all the various accounts and counterparties, said John Rivett, collateral management executive, J.P. Morgan Worldwide Securities Services. Use of a cross-margining capability across all transactions also can help firms reduce margin requirements and related collateral funding costs.

Having a better handle on collateral activities and thus a clear idea of the obligations due will also help financial institutions make more efficient use of collateral inventory.  

Cash still makes up of 80% plus of the collateral pledged in today’s market, but the increased need to collateralize puts pressure on operational teams to use the collateral inventory as efficiently as possible to avoid constraints on the balance sheet. For many firms, this means employing stricter eligibility requirements to ensure the collateral received can be re-used easily and the firm can also analyze the inventory to use the most optimal assets to meet various obligations and avoid funding additional collateral, which is costly, said Rivett. 

“The collateral is only as good as the parameters you put around it. In order to properly manage your risk or manage your collateral, [a firm has] got to be quite sophisticated in the eligibility criteria and this requires significant human and technology investment,” he said. 

Developing the technology and team expertise to monitor and align collateral eligibility with inventory is not a light undertaking so offering support in this function by utilizing established infrastructure is where a custodian can add value to clients, Rivett added.

Custodians are taking the optimization one step further by offering collateral ‘upgrade’ services where the service provider transforms the clients collateral into higher quality assets, such as a government bonds, suitable to meet the collateral obligations for CCP activities.

This type of upgrade activity is typical of repurchase agreements (repo) and stock lending businesses. Many custodians can leverage existing capabilities to offer collateral upgrade services to custody clients.

JP Morgan, for instance, has various divisions including repo desks across multiple currencies, stock lending desks so it is in a good position to offer collateral transformation services to help clients get the correct collateral posted to meet bilateral and CCP obligations, explains Rivett. “JP Morgan has been doing this for years and we are now looking to tie that closer to our collateral management services, but it is something we do as a bank anyway,” he added.

Some prime brokers and custodians, including BNY Mellon, are investigating the options for some type of collateral enhancement service to help clients meet the criteria of the CCP, said Mark Higgins business development director – EMEA at BNY Mellon. Like JP Morgan, BNY Mellon would look to utilize other divisions of the firm to support such a service.

“The real pain point here is that there will be more collateral needed,” said Higgins. “Most people are using cash or G7 government debt so the collateral people use today isn’t that different compared to what is proposed to be used under the CCP model.”

More sophisticated services such as collateral upgrades, may support new market requirements but cost reduction and improved operational efficiency are still driving firms to consider outsourcing, said Higgins.

“There is obviously nothing cheaper then relying on an Excel spread sheet, an Access database and borrowed members of staff – that’s as cheap as it gets, but there are risk and cost implications of managing collateral like that and many firms realize that this is something they should be moving away from,” he said.

With the market changes impacting collateral management directly, financial institutions must have the experienced operations team with market knowledge and reach to adequately meet new regulatory and market requirements. 

The International Swaps and Derivatives Association (ISDA) has published clear best practices all financial institutions should work towards to establish an efficient and automated operation, which further ups the stakes of collateral management practices the buy side should follow in the near future. Many firms are turning to custodians to rely on outsourced services that often exceed the market best practice, said Higgins.

Today buy-side firms may only be able to manage to do a monthly or weekly margin call because the firm lacks the capacity or knowledge to manage the process more frequently, however when a firm uses an outsourced service, they will benefit from a top-notch processing practices and move from monthly or weekly to daily asset valuations, margin calls and reconciliation for example, explains Higgins.

The alternative to outsourcing is to license technology or build infrastructure in-house but unless the firm has the volumes of OTC trades to manage, it cannot justify the operating cost of technology and resources required to either build or support licensed technology. And this situation will not change in the new market environment, noted Higgins.

Central clearing may be a common driver and cause of new market complexities however, players such as pension funds who may be exempt from central clearing will have to improve collateral management to support general increases in collateralization and other requirements, said Higgins.

“Whichever way you cut it, collateral is going to be in the landscape for everybody, he said.  “The type of business that has traditionally come to us will continue to stay with us and for additional external factors will increase their collateral requirements in the OTC space,” said Higgins. 

Pension funds, for instance, will have to collateralize more transactions and will still lack the back office and thus the inclination to invest in operational process compare to a bank, said Higgins.

One of the ambiguities surrounding the custodians’ role in this evolving space is uncertainty around the extent to which the custodians will engage with the clearinghouses for OTC derivatives. 

The majority of buy-side firms will avoid direct clearing due to the cost and CCP membership requirements and will instead rely on general clearing members (GCM), who are mainly prime brokers, to manage central clearing activities and offer additional support services. These GCMs will clear trades on behalf of clients and are likely to offer a suite of additional collateral management functions, which may overlap some custodians’ offerings.

Custodians will have to establish some connectivity to the general clearing members to support CCP activities of its clients, however, some custodians may become GCMs to compete with the prime brokers. Although, this may seem counter-intuitive for the custodians to become GCMs, it is a natural progression for extending services to the buy side, explains Sprackling.

He said: “The key issue for the investment managers with the onset of central clearing is gaining liquidity to meet margin calls from CCPs, and to do that they will need the custodians to help them with collateral enhancement via the repo market. Since the custodians hold the collateral pool it makes sense to bundle the clearing, collateral enhancement trading and collateral management functions as one service.”

Most firms have or are considering drawing on the exchange-traded derivatives clearing and prime brokerage services to support clearing from a CCP perspective. JP Morgan will leverage its other business lines to support the direct clearing activities of its buy-side clients, explains Rivett.

“I don’t need to, as a custodian, get into that space because I have the investment bank and the prime brokerage division doing those activities already,” he said. “What I can do is offer a unique benefit around the collateral service to either support the other JP Morgan divisions or to support our clients and other clearing brokers because we effectively act independently to the rest of JP Morgan.”

BNY Mellon has made its position abundantly clear when it formed BNY Mellon Clearing, LLC, a U.S. registered futures commission merchant (FCM), last year. This new company plans to become a clearing member on major exchanges and central clearinghouses on a global basis to support the trading activities of its clients. 

Other service providers, such as State Street, are still openly exploring the possibility of becoming a general clearing member of clearinghouses, said Centanni.

“There are many other organizations, including custodians, who are trying to understand if this is a logical extension of the business,” said Centanni. “We indeed have been exploring what we have to do to extend our current capability to clear exchange traded derivatives to also handle the clearing of eligible OTC derivatives.”

Regulation is due to become more formalized in the coming months and year, which will give custodians more information to make the next strategic step forward. This does not however, mean the custodians are waiting for regulation to be formalized before extending services to support new client needs, said Centanni.

“In the past you might wait for the regulation to be almost fully formed and then jump in and do the kind of mechanical work that is necessary to be able to comply with [regulation], said Centanni. “But these are big sweeping changes so firms like ourselves are already starting to build out solutions based on what they think will happen and leaving in some flexibility to adjust accordingly.”

And custodians largely know how they are going to expand the services to support new requirements but they are also keeping their fingers on the pulse of regulation changes to adapt services according to new client requirements to shield them in part from the onslaught of regulatory and market-wide changes, he added.

The transformation of the financial industry, and of collateral management specifically, has only just begun and both custodians and the buy side will have to adapt accordingly.

Sprackling said: “This decade will be the decade of collateral as managers battle with the complexity of exchange-traded, bilateral and centrally cleared models, and I think it is fair to say that all of the custodian banks are looking at extending the collateral management services that they provide at the moment…However we have a way to go yet as the buy-side, (and their service providers) will eventually have to get used to intra-day margining if they are going to truly reduce their counterparty risk.”

More Collateral Management Trend Analysis via the DerivSource Collateral Management Series

 This a recent instalment of a series on Collateral Management published exclusively by DerivSource. Please see previous articles as part of this series:

OTC Derivatives Collateral Management: Best Practices & Beyond - August 2010

Pension Funds: Improving Collateral Management for OTC Derivatives through Governance, Software or Outsourcing - Sept 2010

The Buy Side Gets Proactive: Improving Portfolio Reconciliation of Collateralized OTC Derivatives - October 2010

Securities Lending: A Business Opportunity in Collateral Management - November/December 2010

Sell-Side Perspective: The Challenges and Benefits of Collateral Optimisation - January 2011

Exploring Title VII of the Dodd-Frank Act & the Impact on Margin Posed by End Users - Feb/March 2011

* If you wish us to cover a specific aspect of collateral management or counterparty risk mitigation practices, please feel free to get in touch at editor@derivsource.com

 

 

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