Custodians are stepping up their collateral management capabilities in anticipation of the increased margin needs of clients who will soon have to centrally clear and may opt to outsource instead of manage in-house. Lynn Strongin Dodds explores how collateral management may be evolving to look more like custody as asset servicer’s capabilities and client needs converge.
Although the debates and discussions over the impending OTC rules seem never ending, global custodians, universal banks, clearinghouses and software vendors are not waiting for the ink to dry. They have already started their engines and pumping in significant investments into launching new models or re-engineering existing offerings to meet the impending collateral crunch.
“It is interesting how collateral has made the transformation from a back and middle office function to the front office, highlighting the role of collateral,” says Staffan Ahlner, managing director, global collateral management at BNY Mellon. “The challenges have become a large topic but collateral management is definitely a permanent trend.”
The US has been forging ahead with Dodd Frank taking hold this year but the European Market Infrastructure Regulation (EMIR) is not expected to see the light of day until 2014 or even later. Earlier this year, the European Parliament unexpectedly cancelled a vote regarding the so called ‘technical standards’ of the new derivatives rules which had been published by Europe’s chief watchdog, the European Securities and Markets Authority (ESMA) last September.
The Commission gave the green light but influential members of the Parliament such as Welsh Conservative Kay Swinburne and German Christian Democrat Werner Langen, argued that the standards in parts diverged from the intention of the original text which had been agreed upon by all parties. The concern was that they could disadvantage real economy users of derivatives.
Despite the divisions and uncertainty over the final version, there is no disagreement over the belt tightening that collateral will incur. Buy-side firms will be required to post higher initial margins for all over-the-counter (OTC) transactions to clearinghouses that in turn are expected to only accept the conservative variety of government bonds or cash. Dodd Frank and EMIR are not the only culprits as Basel III aims to strengthen the banks’ capital reserves through holding greater amounts of liquid assets or high-quality eligible collateral against financial exposures.
Putting an exact figure on the shortfall has been tricky and seems to be open to interpretation. Estimates vary widely from the $700bn to $1.2tn forecast in Moody’s Investor Service’s recent report entitled “Managed Funds: New OTC Regulations Will Boost Demand for Eligible Collateral” to the International Monetary Fund’s projections of $2 trillion to $4 trillion. Meanwhile, the Bank of England figure stands between $200 bn and $800 bn.
On the non-cleared front, the International Swaps and Derivatives Association (ISDA) is looking at between $1.7 trillion and $10.2 trillion. The discrepancies can be attributed to the assumptions that are factored into the equations, according to market participants. Numbers can be skewed if FX and forwards are excluded or if netting is taken into account. In addition, the projections are also based on how the financial world is currently turning and does not take into account for the way the market might change as a result of the new rules.
The bottom line is that “the tectonic plates are moving,” says James Tomkinson, specialist in OTC clearing and collateral management at Rule Financial. “EMIR is not completely resolved and although there is a bit of a wait and see attitude, the buy side have to get their heads around what is required. The sell side are more engaged than last year and are identifying the solutions that will be needed for the post Dodd-Frank and EMIR environment.”
Ted Allen, vice president, collateral management at SunGard’s capital markets business, agrees, adding,” We will see these regulations hit in the US in 2013 and we will definitely see an increased interest in collateral management as the new world takes hold. Financial institutions are making more effort to better understand the costs and there is a greater appreciation for the need of robust processes. One of the biggest challenges for the buy side will be the operational cost and whether they should do it themselves or outsource.”
Some believe the lines in the investment sand are being drawn between the larger houses going down the DIY route with the smaller to medium sized firms parcelling out the services. Others feel the divisions are more blurred. “I do not think there will be such a split between large and smaller fund managers,” says Michael Wagner, partner in the financial services practice of Oliver Wyman differs. “Many of the bigger fund managers already outsource their back and middle office as well as custody services because they are focusing on product innovation. It would not make sense for them to upgrade their systems for collateral management.”
Martin Higgs, senior vice president at State Street, agrees adding that “medium sized players do not necessarily want to outsource everything. They may want to keep control over some functions such as payments but the collateral piece is growing too big for them because of the regulatory demand. However, I think the buy side are looking at the new regulations as a whole and not just the collateral management requirements when making their decisions to outsource.”
This is perhaps why there will be those that share the responsibilities. As Barry Hadingham, head of derivatives at Aviva Investors points out, “We outsourced our collateral management functions to JP Morgan and the arrangement will continue but we will keep the securities lending activity in-house. However, I think as the whole OTC clearing landscape shapes up clearing will begin to look more like custody because of the assets and segregation that will be required.”
Raj Shah, global head of collateral management, Citi Transaction Services, also believes that the collateral management industry will follow in the same footsteps as custody. “At the end of the day, it is about scale and efficiency which will help drive down costs. I don’t think there will be a dominant provider but I think it will follow a similar path to custody where 15 to 20 years there were many players but over time it was cut down to four or five.”
Tomkinson imagines that there will be a hierarchy of institutional offerings. “There are firms such as BNY Mellon, Citi and JP Morgan who have allocated a lot of resources in order to develop their solutions and are well placed to provide an integrated collateral solution for both cleared and bi-lateral trades,” he adds. “At the other end of the spectrum there will be institutions who are not necessarily looking to differentiate their offering but need to develop their capability simply to stay in the game and retain their current client base. Obviously there is a need for all the custodians to offer at least the minimum collateral capability because if they don’t provide their clients with a solution, others will.”
In fact, the Oliver Wyman/Morgan Stanley report published last year found that investment banks were eyeing collateral management services as a new profit vein against the backdrop of declining trading volumes. It estimated that regulatory changes could lead to trading revenues declines of between 20% and 40%.
Custodians, however, have taken up the mantle in order to protect their natural turf. The past couple of years has seen them not only honing existing products but polishing new ones. Citi, which launched its Collateral Open Collateral unit in 2011, for example, recently struck a deal with Euroclear and Clearstream whereby the US based universal bank makes securities that it holds in custody for mutual clients available for use as collateral by the two international central securities depositories (ICSDs). The assets will remain under Citi’s custody, and the tri-party agents manage the collateralisation process directly from client trading accounts.
BNY Mellon, on the other hand, pulled together businesses devoted to segregating, allocating, financing and transforming collateral under a new unit called global collateral services. Services range from broker-dealer collateral management to securities lending, collateral financing, liquidity and derivatives servicing.
“The goal was to provide a holistic solution and tear down the silos,” says Ahlner. “We have a well-established tri-party service offering real-time views of collateral positions and have expanded our platform over the years to include other participants such as clearinghouses, buy-side clients and corporates. We also answer multiple margin calls leveraging existing technology initially built for securities lending or repo transactions. Collateral management is an expensive business especially when looking at the data requirements, the validation pricing for example. As collateral management is constantly evolving you need to be able to continue to make significant investments in technology.”
John Southgate, head of derivatives and collateral product management at Northern Trust, agrees adding that over the past year the firm has seen a sharp increase in the number of existing as well as new clients outsource their collateral management functions. “What we are seeing is clients wanting a single provider so that they can obtain efficiencies across their collateral pools and asset classes. They do not want to fragment the function across different firms. We are looking to develop long term partnerships with large clients as well as those with smaller portfolios which will grow over time.”
