Investment managers can transform collateral management into a profit centre by generating returns on collateral through securities lending activities. ISC’s Sean Sprackling explains how the buy side can adopt this method used widely by sell-side institutions.
Q. Using a traditionally back-office process to generate profit is a radical idea to many financial institutions and especially for buy-side institutions. Can you explain how the sell side currently leverages its collateral to generate profit and how the buy side can learn from this model?
To many in the buy-side it may seem like a radical idea, but this is something that the sell-side has been doing for years. By netting and collateralising their counterparty exposures, sell side banks reduce their capital requirements as well as their counterparty risk. However there are other ancillary benefits, including optimising the overall profit generated by the business by running an efficient collateral management operation. They view Cash reinvestment as a business in itself with the concomitant rewards (and risks) of any trading business.
In the buy-side the usual model employed is to move cash collateral into a vanilla money market fund in order to match the re-investment rates enshrined in their contracts, often merely farming it out to external money market fund providers (who take a cut themselves). The sell-side, however, will reinvest the cash in a variety of investment vehicles and asset classes and across a range of durations in an effort to maximize yield. The success of such a strategy is predicated on the ongoing ability to maintain a stable level of diversified risk, but if managed properly can generate significant profits over and above the Sterling Overnight Index Average/Fed Funds (SONIA) rates that they require under the ISDA contracts. The key is to closely manage the cash collateral pool, and work out how much is required for margin calls, how much can be put out overnight and how much is “sticky” i.e. how much you can put into longer duration products such as term repurchase agreement (repo) transactions.
Q. Why hasn’t the buy side adopted this strategy in the past?
There is no easy answer to this question, as it seems like a logical investment strategy. My guess is that because the concept of efficient cash re-investment comes from the Securities Finance community, and most buy-side firms traditionally leave stock lending to their custodians, there has been very little focus on it. It has only been in the last decade that the buy side’s use of OTC derivatives has reached significant volumes so collateral management has often been seen as a back-office function rather than an investment decision, so most firms are not set up to deal with the added complexity of running a cash re-investment desk.
Q. Why would a buy-side firm consider adopting this method now?
We may be over the horrors of the Credit Crunch, but margins are still tight, interest rates low and investors are demanding more efficiency and better risk management from their investment managers. With the seemingly inexorable rise of UCITS funds, most buy-side firms will increase the use of OTC instruments, but with this comes increased operational and systemic risks. Industry and regulatory developments towards central clearing and data repositories will undoubtedly add to the mitigation of operational and systemic risks (at a cost), but they will not completely remove them. In particular the establishment of central clearing houses will certainly increase the robustness of the OTC infrastructure, but not all OTC instruments are or ever will be suitable for clearing. To work in a central counterparty model instruments must be liquid, have standard terms, and be price transparent. Many current instruments (such as CDS on exotic indices, single name CDS, and bespoke interest-rate products) do not have these qualities. Firms must therefore maintain and enhance their bilateral infrastructure in order to ensure firm and industry-wide counterparty risk management.
Q. What are the changes a firm would need to make to its collateral management and securities lending infrastructure to accommodate this method?
This of course depends on how the firm is currently running its operations. Most firms outsource their collateral management and stock lending operations to one of the big asset servicing providers, in which case the first step would be to call them in, explain your requirements and see what options they can offer. However you must of course understand what your requirements actually are. With the firms that I have been working usually the first step is to analyse the cash collateral pool to see what the fluctuations in balances are during a year, and thus what is “sticky” and what needs to put on overnight and so on. Clearly moving to a more complex cash re-investment strategy requires more (risk) management from the firm, rather than merely looking at reports from the money market funds to see whether they have beaten SONIA or not, and of course therefore requires front office as well as middle/back office expertise to make those investment decisions.
Firms that run their collateral management in-house are far more likely to have the infrastructure and expertise to do this, but even now most collateral management systems do not have the ability to manage side-by-side repo trading and most stock lending systems are not designed to handle OTC Derivatives collateral management, so there would have to be some integration effort to manage the collateral pool.
Q. What are the cultural obstacles a buy-side firm is like to encounter in making this strategic change?
That’s a very poignant question, as the biggest obstacle in setting up this kind of operation is indeed cultural. Changing to a more complex re-investment strategy obviously requires some investment in people, processes and systems, and convincing executives to write a cheque for something that is traditionally thought of as a back office operation is not straightforward. As aforementioned, whilst it can increase the potential for profit, as a trading operation it can also increase the potential for risk in an area that a firm may not have the skills or experience necessary.
Q. What is the biggest challenge in setting up and operating this method?
The biggest challenge by far is risk management. Firms should not even contemplate this without understanding that collateral cash re-investment must be run as a trading operation, and that therefore the risks of that trading business must be managed on a day-to-day basis.
Q. What are the biggest benefits? Are there second benefits other financial benefits?
The biggest benefit is of course financial – turning a cost into a profit centre. It can also be a useful sales and marketing tool, as running a more efficient collateral management operation and potentially sharing excess profits with clients would be a boon. Finally it can be useful, in the current climate, for fostering a more advanced risk culture within a firm.
Q. Many buy-side firms are considering outsourcing collateral management. Will the understanding of this method encourage some firms to reconsider outsourcing collateral management?
Yes, I think it will. Most of the service providers are now geared up to provide these kinds of services and are flexible enough to provide what their clients require. They also have all of skills and experience in-house to provide good advice on exactly what strategy should be followed and can often therefore be a much cheaper option than buying in the skills and setting up an in-house operation.
Q. What advice would you give to these firms about utilising fund administrators to achieve improved returns on collateral through the use of the fund administrator’s margin re-investment services?
Be clear about what you are trying to achieve, and the level of risk that you are willing to take. Look to partner with the provider and make sure that they are able to give you the flexibility and the service that you require.
Q. Do you expect many buy-side firms to consider this approach in the coming months?
I would like to think so. The buy side are quintessentially conservative organisations that take a considered approach to change, but there is a clear benefit here to be had. Most (good) sell-side practices eventually are mirrored by investment managers, so I do expect this strategy to gain ground over time as the buy-side continues to grow its use of derivatives.
* Sean Sprackling is an independent consultant for the buy side and expert in collateral management.