Q. What is the biggest change you have seen in the last year in the way investment managers manage collateral and portfolio reconciliation operations?
Since last fall, the buy side has really started taking a more serious look at what counterparty risk truly means. Traditionally, investment managers have good counterparty risk controls in its relation to trade settlement risk. However, with the market conditions as they are now, investment managers are looking at risks related to particular derivatives contracts and how to better control counterparty risk more generally. Also, the collapse of Lehman Brothers in September revealed the vulnerability of some of the big banks and as a result many of end clients (such as pension funds) have started requesting more information about a investment manager’s counterparty risk management procedures and more frequent reporting of such risk-related data.
Both the recent market events and the new demand from clients for regular updates on risk management processes means buy-side firms need to change their operations to support the management of this broader definition of counterparty risk. One major change is that investment managers no longer only review the counterparty risk of the complex derivatives products, but review all deals including more vanilla types like FX forwards or Mortgage TBA’s (which behave like a forward). TBAs, for instance, was an instrument type that was clearly problematic post-Lehman bankruptcy and Securities Industry Financial Management Association worked diligently to set up calls, execute unwinds of the TBA’s contracted with Lehman as a counterparty. Investment managers now realize a TBA is another type of forward and that poses a risk. These types of redefinitions are what the industry is wading through right now.
In the re-assessment of counterparty risk firms are looking to improve operations surrounding collateral management and reconciliation to support greater risk management needs. For example, financial institutions used to reconcile their positions once a month with counterparties, but now most are looking to move the reconciliation frequency to a week or ideally to a daily process. And in reconciliation, I mean the any asset type that presents a counterparty risk as well as reconciliation of assets to used for collateral. We are seeing this trend more and more as the year progresses.
Q. Do improvements in counterparty risk management include restructuring of the departments? If so, how are firms handing this organizational change?
I think buy-side institutions have started looking at some of the more fundamental functions that they need to do that they were not doing before.
I recall a discussion I had with a hedge fund 18 months ago where I asked the manager what his process was for checking the accuracy of a margin call when received by a counterparty and the manager’s answer was ‘we don’t check; we just assume it is okay." Two years ago this lack of process may have been acceptable, but the industry has changed dramatically since then. Some traditional asset managers have historically been better at tracking collateral so they at least know if the margin call received by a specific counterparty is in the right ball park and if the call is expected, but now all buy side firms are reviewing collateral management operations with the aim to build out the capability (software and staff) required to manage risk and collateral movements with greater care, efficiency and control.
When meeting with clients we are actually seeing many firms who are trying to set up collateral management structures for themselves for the first time. I think this is a sign that investment managers are realizing now that they need to take more ownership; they need to be able to calculate the collateral obligations, see what assets are available to post as collateral, what have they already posted, and where is it located and ensure they can get it back when necessary. To do this, firms are either to build out collateral management and reconciliation operations or outsource these functions to Investement Management Outsourcers (IMO’s) and Hedge Fund Administrators.
For custodians with IMO services collateral management is a great value-add service because they are the safe keepers of those assets and they can provide more services to their clients. Also, I think some investment managers realize that they may know very little about these types of operations and they would prefer just to outsource rather than add extra departments, staff and software required in order to get such an operation up and running efficiently and smoothly. The intention this year may be on improving risk controls but all firms are working with very tight budget constraints and will consider headcount and other potential increases in costs when debating what strategy to adopt to improve risk management procedures.
It is important to note also that firms approach counterparty risk in different ways; some firms are more focused on reconciliation while others want to sort out collateral management requirements. More often an investment manager first wants to ensure it knows what its portfolio and derivatives positions look like and the collateral required of them before one even begins reconciling with anyone else. So focusing on collateral management first seems a very logical thing to do.
Q. Are there other areas within collateral management that need to be improved?
One thing we are focused on is dispute resolution. With three-way reconciliation there is no protocol for how the dispute resolution process begins or is executed generally. And with three parties involved the process can easily become a three-way wreck.
It makes sense for the primary players (the investment manager and dealer) to reconcile first but the custodians want more transparency so they can resolve any discrepancies with the data they have but the investment manager also has to sync up with the custodians with regards to the value of derivatives portfolios so the custodian can report to the end clients. It is important that there is clear transparency between all parties so they all can come to a consensus easily and when dealing with discrepancies. Dispute resolution is rapidly becoming the next focus for this industry and as consequence we are pushing our centrally hosted exception management service, Crosscheck for firms interested in streamlining counterparty communication and related workflow functions.
Q. What are firms doing to tackle inefficiencies on an industry-wide level?
We see more buy-side firms getting involved in industry groups focused on reconciliation standards. The Asset Manager’s Forum (part of SIFMA) started up a derivatives operations committee about a year ago and already within this committee there are several new working groups, including one focused on ‘new three way reconciliation group.’
Three-way reconciliation is an issue which had previously lacked attention. As stated before, on the buy side, reconciliation requires the involvement of the investment manager, prime broker and/or custodian or third party administrators, and the involvement of three parties can create three-way breaks and inefficiencies in the process. There is currently no established protocol for dispute resolution when reconciling portfolios but this new group aims to form some best practices for players to abide by.
We are also starting to see the commitments around reconciliation and collateral management outlined in Fed letters to include the buy-side community. In fact, the ISDA collateral committee is currently conducting a feasibility study to review the extension of these commitments to include the buy side. And other working groups operating within the ISDA collateral management committee will address market wide standards and best practices for these processing areas. The creation of these groups has helped in getting the buy side involved in more industry initiatives.
* Jack Dixon is director of Derivatives at Omgeo.