Financial institutions are increasingly centralizing collateral management on a firm-wide basis to improve optimization capabilities and support more stringent credit counterparty risk mitigation practices. In a Q&A, SunGard’s Ted Allen explains the opportunities and challenges in moving to an enterprise-wide approach for collateral management.
Q. How have market changes post-financial crisis altered how financial institutions manage collateral and credit counterparty risk?
There have been some major changes to the bilateral Over-the-Counter (OTC) derivatives market as a result of the financial crisis and specifically, the default of Lehman Brothers.
Firstly, prior to the fall of Lehman Brothers in September 2008, many buy-side firms had posted collateral, both initial margin and variation margin, on OTC derivatives trades to the broker. During the unwinding process after the bank’s default buy side firms found that the initial margin, or independent amounts, pledged to Lehman Brothers had been rehypothecated by the bank, which is common practice, and this meant the independent amount collateral were gone. As a result, the buy-side firms have no choice but to re-join the long list of creditors for the bank.
So, one of the by products of financial crisis, is that financial institutions now recognize that counterparty risk really cuts both ways – between both sell-side and buy-side institutions.
And in response to this realization, financial institutions are increasingly demanding that independent amounts are not rehypothecated and are either held in segregated accounts or held via a tri-party agent. This represents quite a change for the banks that are no longer able to re-use those funds increasing the strains on liquidity.
Secondly, regulatory reform of the financial industry with both the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) in the U.S. and the European Market Infrastructure Regulation (EMIR) in Europe introduces stricter rules around margin requirements, and especially through central counterparty clearing (CCP).
Specifically, the move to central counterparty clearing for OTC derivatives will likely mean total margin requirements the banks have to put up are greater as they too will be posting IM and the potential loss of netting effects as the portfolios spread across bilateral trades and multiple CCPs.
Couple this with the increased capital charges of bilaterally settled trades and the net overall effect is that liquidity will be squeezed. Sell-side firms will have to be much more careful on how they pledge out collateral. A global view of the available portfolio, across product lines including listed and OTC derivatives and securities finance enables a firm to assess what collateral is best used and make this strategic decision at the point of pledge. More specifically, the firm must also have information on the eligibility requirements and the ability to calculate the cheapest collateral available for delivery to optimize the collateral used to meet obligations.
Q. Besides the market-wide changes from the credit crisis and regulatory reform, what are the direct drivers pushing firms to adopt cross-silo collateral management strategies today?
Collateral management was traditionally seen as a back office activity separated from the trading activity where the focus was on risk management and control. These changes in the market infra-structure mean this is no longer the case and revenue generation (or at least cost reduction) is becoming more important. Choosing the right collateral to pledge at any point in time based on the relative costs and eligibility schedules is an important economic decision that is now being made in the front office. The prevailing strategies are to make the most optimal use of the assets available and to have the ability to apply consistent standards around the process of collateralization as a means to reduce operational risk in the process.
The move to central clearing of OTC derivatives creates further opportunities for consolidation of collateral activity. Whilst some of the regulatory requirements are still unclear at this stage, firms are leveraging their infrastructure around listed products to provide a similar service for centrally cleared OTC products. Being able to provide a consolidated view of collateral requirements across silos and to offer ancillary services such as collateral transformation and optimization becomes a key competitive advantage.
Q. What does an enterprise-wide strategy look like and what are the challenges in developing such an operation?
Firstly, an enterprise-wide method to managing collateral refers to a firm’s ability to view and manage collateral inventory and obligations on a firm-wide basis and across product lines, possibly across business lines and on a global basis, if needed.
The first challenge is the silo-based approach businesses have grown up with. Each product silo works in isolation and often the teams have their own way of operating, own technology and organizational structures. So, one of the challenges is recognizing how to break down these barriers from both an operational and technological point of view.
For instance, data is always an issue when building a cross-silo approach to collateral management because firms must source the data available and apply the data in consistent and usable formats within an appropriate time frame. Standardization of the data into a normalized format is a key task because real-time views of exposures, of positions and collateral settlement is essential to make sure the optimization process is an efficient as it can be.
A further complication is that firms generally have vertical product silos and horizontal regional silos so there are geographical, currency and settlement considerations to be had when managing collateral on a firm-wide basis.
From an optimization point of view, managing collateral across silos is challenging because the firm must continue to monitor the assets pledged as the profile of the assets changes in market conditions. For instance, the firm needs to be able to view the portfolio and what has been pledged out already to assess if this is the most optimal assignment of assets to meet that obligation or if assets should be substituted to reduce the overall collateral cost. This ongoing collateral calculation required in the optimization process must take into account various details of the collateral, including eligibility and haircuts across all asset classes to support the constant recalculation of asset assignment. There are multiple factors to be considered in this calculation including settlement timings, failure and transfer processes which will vary depending upon if the collateral is included in a bilateral or CCP trade or if managed on a tri-party basis, for instance.
Another challenge is applying consistent practices across asset classes. Specifically, OTC derivative collateral agreements tend to have a very rigorous documentation that is extremely prescriptive in that all details, such as how the collateral is communicated and calculated, is clearly laid out in the documentation and widely adhered to. By contrast, the repo and securities lending documentation is less formal. That is changing however and as a result, there is a move towards applying common standards of practice for OTC derivatives and repo/securities lending. The result is an enterprise collateral operation that optimizes collateral across a single common pool and applies similar processes and procedures.
Q. What are the main benefits of adopting an enterprise-wide approach to collateral management?
Collateral management touches many different areas of the firm, from risk managers, traders, operations and of course senior management. Whilst these different constituencies may have different requirements, it is clear that all benefit from a holistic view of collateral and exposure. In short, firms move to an enterprise basis to establish a more operationally efficient, cost effective collateral management operation that is capable of supporting collateral optimization and even revenue generating activities, such as collateral trading. However, there are various timely benefits associated with efficiency and optimization, which are worthy of mention.
For many financial institutions, collateral management is no longer just a back-office activity, but a revenue generating function and clear priority for firms who are creating collateral trading desks that are directly responsible for achieving optimization of that collateral portfolio and run profit and loss from that.
At the same time, firms want to reduce operational cost associated with this processing function which a global view of collateral inventory enables because making best use of collateral held to meet obligations reduces the need for a firm to go to market to fund additional collateral required.
The introduction of central clearing for OTC derivatives will increase the cost associated with managing collateral because firms will be clearing via multiple CCPs, all with different margin requirements, which combined with bilateral activities reduces the ability for a firm to cross net exposures and margin requirements and this increases collateral costs and may well prove a disincentive to hedging if the ability to net exposures is lost.
An enterprise-wide approach gives the sell-side institution an opportunity to net collateral movements for its own trades, and for its clients, so rather than getting calls from all different desks, the firm can produce one netted margin call, which could be a simple aggregation of the requirement calculated on the original agreement or could be taking portfolio level view of exposure to generate a single collateral requirement off the back of that.
Q. How do you see this trend evolving over the next couple of years? Will enterprise-wide approaches to collateral management become the norm?
This trend continues to manifest itself more every month, and it is unlikely that it will go away or be reversed for all of the reasons previously discussed. One of the single biggest things that the financial crisis highlighted is the need to have a more holistic view across the business. At SunGard, we are seeing this trend reflected across multiple areas within financial markets, and enterprise collateral management is at the forefront.
