Banks are optimising collateral to keep competitive in a new market environment. In a Q&A, InteDelta’s Nick Newport explains the opportunities and challenges in re-using collateral to fund other trading activities.
Q. What are the main drivers pushing banks and broker dealers to optimise the use and re-use of collateral?
Banks are keen to drive the most optimal and cost effective use of the available inventory within their own organisations to generate returns and to finance additional borrowing. Under this approach, firms can gain significant value by having a real time view into available collateral and re-investing this in the most optimal way possible. Alongside this, banks also want to be able to identify all available assets across their organisation which it is possible to utilise as collateral, even for short time periods. The aim of both elements here is to squeeze the maximum economic benefit out of the firm’s existing inventory.
Q. How is new regulation affecting this trend?
Regulation is helpful to keep in mind but is not necessarily a direct driver for optimisation. Certainly, there are some important implications of new regulation around what collateral is available to be re-used. There are, for instance, some potential limitations to re-hypothecation that are coming out of the new regulatory environment, for example in the Dodd-Frank Wall Street Reform and Consumer Protection Act and the equivalent European Union regulation. Specifically, the segregation of initial margin will impact the ability for a firm to re-hypothecate or re-use that collateral and there are likely to be other restrictions that will emerge in this area. Evolving liquidity regulations are also starting to impact some of the details of how banks optimise their collateral.
Q. How do banks currently optimise collateral and what are the new methods used to increase opportunities and benefits of collateral use and re-use?
Sophisticated collateral optimisation capabilities are already in place at a number of the leading financial institutions. In addition to these, it is worth noting that the tri-party collateral agents have also developed leading edge optimisation techniques in similar ways. Across the majority of participants in the bi-lateral collateral market however, true optimisation is still very much an aspiration rather than a reality.
At the most basic level, collateral pledging decisions are made within the individual product silos (repo, securities lending, OTC etc) by the operational collateral management teams based upon the availability of collateral received within that silo. Requirements over and above this are then sourced from the respective financing desks in the front office, often separated between fixed income and equity. These financing desks however struggle to optimise, even for these shortfall amounts, as – for example – they do not have transparency into the eligibility profiles for the clients in question. As such, cash is often used to fill the gaps (which is not the optimal asset to give). This is the fairly rudimentary position many banks are starting from. Given this, a significant number of banks across the market are currently looking to enhance their ability to optimise collateral inventory usage.
Moving from this position to being able to gain the most benefit from optimisation, requires significant change on multiple fronts, such as organisational re-alignment, data integration, technology and infrastructure enhancement as well as the development of sophisticated optimisation modeling techniques. These need to go hand in hand. Without having a timely view into the firm’s inventory and having people with a mandate to make collateral pledging decisions across the holistic process, even the most advanced modeling will not achieve the benefits banks are aiming for.
As a result, for many banks significant effort is being put into pulling together a real time, cross organisation view of inventory, incorporating assets in clearing accounts as well as those assets that are placed as collateral under Over-the-Counter (OTC) derivatives, securities lending and/or repo activities. The ideal scenario is to bring all assets together in a single view and then run a sophisticated optimisation process on the entire inventory. So far, many organisations have managed to centralise some of this information, enabling the first steps towards optimisation.
With this integrated view in place, banks also need to implement technology with the flexibility to define the required rules and parameterisation for optimisation, incorporating multiple elements such as asset liquidity, valuations, upcoming settlements, upcoming corporate actions, haircuts and eligibility criteria.
For example, if an organisation is holding positions in emerging market equities, which have a longer settlement cycle compared with developed market equities, it might want to establish different availability rules on these different asset types (i.e. the assets with the shorter settlement cycle remain available for longer). Alternatively, if two counterparties both accept a given asset which is currently being held in inventory, all other things being equal, the optimisation routine might aim to place it with the counterparty which has assigned the lowest haircut for the asset. Depending upon their individual inventory management approaches, banks look to set multiple variations on such rules in combination.
Q. What are the challenges in optimising collateral in today’s operational infrastructure?
Firstly, for many organisations, the reason why collateral optimisation has not moved as quickly as it might have done is often because of organisational issues. Historically, banks have been organised in silos where asset classes, such as fixed income and equities, operate discretely with little cross-over. However, in order to optimise collateral inventory to the greatest extent possible, a firm needs to have a single, comprehensive view of all the assets across these desks, including assets placed under OTC agreements.
In addition to this cross-product view from an organisational standpoint, the second major challenge is getting a consistent, timely view into the available assets across the entire organisation, including across business lines and entities. Only with a cross-product and cross-organisational view of inventory can a firm begin to optimise collateral effectively.
Q. When will a firm decide to buy or build the technology to support collateral optimisation?
Small to medium-sized banks are more likely to seek out vendor solutions for improving collateral inventory management and optimisation, whereas larger banks generally build capability in-house.
A typical organisational/operational model for this is that the optimisation usually takes place under the umbrella of a bank’s equity finance area as this is where the thinking around optimisation process is most embedded. Therefore, it is common for a bank to leverage existing equity finance infrastructure to build out optimisation capability. For this reason, collateral optimisation modules often operate as a component within this wider equity finance technology infrastructure.
Compared to the OTC margining space, which is very competitive from a technology perspective, the collateral inventory and optimisation software space is much newer. There are some solutions available today but this is an area of continuous development as vendors work out what the market needs (both for today and for the future). Again, flexibility in such technology is critical, to enable banks to implement these tools to suit the specific way they want to manage the process through the use of different calculations and methods for optimisation. There is a big opportunity out there for vendors and I expect developments will continue as vendors look to capitalise on the ongoing investment into this area across the banking market.
