Collateral optimisation strategies can range from simply identifying the cheapest-to-deliver assets to much more sophisticated strategies, which include optimisation algorithms. In a Q&A SunGard’s Ted Allen explains the drivers and challenges firm face when implementing collateral optimisation strategies used by to support central clearing of cleared swaps and increased demands for capitalisation.
Q. What is collateral optimisation exactly? What are the drivers influencing plans for most firms you work with?
Optimisation means many different things depending on the firm in question and the aspirations of the organisation. When we, at SunGard, talk about optimisation, we are talking more about how a firm can use the assets in the most optimal way to meet its global set of collateral requirements. The goal of the optimisation process is to minimize the cost of collateral that is posted out. Many market participants are exploring this type of optimisation now and this focus is driven by the increased demand for high quality assets to meet collateral requirements needed to support the regulatory mandated move to central counterparty (CCP) clearing as well as the greater economic capital firms will have to set aside in accordance with Basel III requirements. New regulation generally is putting the pressure on firms to make better use of their assets, so firms have to be smarter about how they assign assets to meet specific collateral requirements.
Historically collateral management was much more of an operational discipline but it is now moving to the front office and is focused on a cross-business lines. Firms are recognising that a single asset has many uses – it can be used for trading or for collateral activity across a number of business lines. To make the best use of what is available, many firms have been on working on centralising the collateral management function across the business lines and possibly into a single collateral management front office function responsible for making decisions about how collateral gets allocated across the enterprise.
With the introduction of central clearing for some OTC derivatives, many organisations are looking to offer collateral transformation or collateral upgrade services to their clients. Naturally, to support this new business offering, these firms will have to ensure they are optimising both their assets against their own requirements but also have the infrastructure in place to support optimisation services offerings to their clients via client clearing services.
Q. What are the steps firms are taking to implement a more sophisticated collateral optimisation strategy?
Most firms will have implemented the first step in an optimisation strategy which is to look at the collateral requirements sequentially and choose the best asset for each individual requirements. This is performing ‘cheapest to deliver’ analysis of each available collateral call to work out what collateral to assign to meet each collateral requirement one by one. This optimisation procedure can be done across business lines for all collateralised trading activities such as OTC derivatives and repurchase agreements (repo).
Of course, the sequential-based procedure does not offer the most optimal solution. Working out the optimal allocation of your collateral requires running sophisticated alogorithms over a a global set of requirements and an up to date inventory of available assets. The inventory also need to include the collateral already posted that could be substituted.
Once an organisation has the global set of assets, it can run the optimisation algorithms to determine how all sets of requirements can be most optimally satisfied so the total cost of collateral pledged as a whole is minimized. Looking at the requirements individually will not get you there.
Q. What are the biggest stumbling block banks encounter when trying to optimise collateral?
Many of our initial collateral optimisation conversations with potential clients begin with a focus on getting this real-time view of collateral inventory. Data collection and aggregation is the biggest stumbling block for firms. Various types of data to make up the full view the current collateral requirements such as eligibility, haircuts, market data, available inventory and concentration limits must be inputted into the optimisation calculator. For most firms this is a challenge to get that data pulled together in one place, particularly when trying to optimise across business lines and geographies.
Q. What role does technology play in the more sophisticated optimisation strategies? For instance, is ‘what if’ tools now an essential part of margin management?
The foundation of any optimisation strategy is an up-to-date inventory to be able to run optimisation off and technology is a major part of establishing this. Some firms are leveraging existing inventory platforms or building new ones and we offer a modular enterprise collateral management solution, which includes optimisation and real-time inventory functionality.
Also, use of ‘what if’ tools, as part of an optimisation strategy requires supporting technology. With ‘what if’ tools, a firm can no only look at what its optimal use of collateral today to reduce the cost, it can also to evaluate scenarios in stressed conditions, such as a downgrade, and view what impact this would have on the collateral requirements and thus the inventory they would need to. Such what if scenarios are a a great advantage to optimisation tool because it can give a forward looking view to funding requirements and thus help the firm gain a better understand of the risks in the collateral portfolio.
Q. Do you have some practical advice for firms who are about to start implementing a collateral optimisation strategy?
Firstly, firms need to consider how quickly they need the optimal allocation calculated. If the algorithms aren’t configured properly it will take too long to run the optimisation calculation for the solution to be worth the while. It means the firms have to be smart about how they frame the optimisation question and take certain pragmatic decisions regarding the accuracy of the output to keep the performance of the algorithms within acceptable times. For example, when a firm runs the optimization it will be running that over inventory that is being actively traded. which means The performance needs to be fast so that trading can continue. Also when you’re getting close to the wire, you need an answer about how to assign your assets quickly to make sure you get the trades booked in time.
Finally, taking a step-by-step approach to implementing optimization across business lines is an option. The goal of a global optimisation across the enterprise might not be practical for operational, infrastructure or political reasons. Firms will have to sell the benefit of operating from a central pool to the firm as a whole rather than each line of business using assets for their own purposes, which can be a difficult undertaking. In short, it is better to optimise with a single business line rather than not at all, if global optimisation isn’t possible.
Q. What do you think the next phase for collateral management will be?
Regulatory change is having such a huge impact on the collateral management space that the whole approach is having to change. Enterprise collateral management and collateral optimization clearly have become essential rather than nice to have. We expect that pressure to continue as the market evolves to this new reality. Increasingly firms are taking into account the cost of collateral in their trade pricing to gain more focus and ensure the true economic cost of the deal is reflected in the pricing, so collateral will continue to play an increasingly important role in investment and trading activities for financial institutions going forward.
Also, this continued focus on collateral optimisation tools to generate the required collateral trades would increase the velocity of collateral movements. Organisations will have to invest in technology and infrastructure to keep up to the increased number of collateral movements, so initiating substitutions and new pledges and that whole process of working out and booking the movements will have to be automated.
