In Q&A with DerivSource Cubillas Ding, Research Director, Capital Markets & Risk, Celent – Oliver Wyman, shares the highlights of a recent survey among buy-side firms plan to maximize collateral management operations to meet new regulatory requirements and greater capital requirements that are transforming the OTC derivatives marketplace.
Q. What did you aim to uncover in this piece of timely collateral management research?
The study’s intention was to understand from senior executives and industry experts on the buy side how they see the future of their collateral operations and IT infrastructure. We discussed how the organizations are creating strategies to support their own goals to meet new challenges introduced by new financial regulation. We interviewed operational and IT executives at investment management firms, pension funds and insurance arms of buy-side organizations. The interviewees were executives within these firms that are responsible for delivering solutions and strategies to meet regulatory initiatives.
Q. What were the main findings that came from the study?
There were two major findings from the study in terms of what the buy side sees as major market and industry drivers.
The first driver noted was the pace of regulation, which is no surprise, as regulation is creating significant operational challenges for the buy side. Approximately 90% of organizations interviewed noted strong pressures from regulations including Dodd-Frank, EMIR but also banking related regulation such as Basel III, as driving change in the their collateral management infrastructure.
The inclusion of banking regulation as a driving force is interesting because the industry now has a situation where new regulation that doesn’t directly cover the buy side, such as Basel III, clearly has implications for this market sector. Specifically, Basel III introduces greater capital requirements imposed on the banks and dealers will change their behavior. Many banks, for instance, may be forced to retreat from market making activities, reduce trading inventories or cut back on commitments to clients as a result of some of the capital restraints they will soon face. This means that costs may be passed on, competition will be reduced between dealers, and it may be more expensive for buy-side firms to trade as a result of the squeeze banks encounter.
Another area of significant concern cited by a quarter of the study’s respondents, was the ability of firms to cope with anticipated 100 to 150% growth in margin call traffic. These anticipated explosions in margin call volumes have implications from both an operational and resourcing capacity and will undoubtedly impact the firms’ ability to be able to manage collateral efficiently in the new derivatives market environment.
A larger number of the study respondents cited that in their current collateral management operation, they already have challenges with inefficiencies in meeting margin calls – even prior to a move to central counterparty (CCP) clearing. Based on these two findings, our study suggests that even a 50% margin call increased would be problematic for certain firms so the anticipated increase of calls to 100 or 150% would push already tight resources to breaking point.
One reason behind the lack of scale needed to support volume growth is that many firms still rely on spreadsheets or in-house legacy applications to complete any of the processes to meet the calls for collateral, respond to exceptions and validate some of the collateral valuations received from counterparties and clearing houses, which are not fit-for-purpose. For instance, a firm may value collateral manually, which means when it receives calls from multiple counterparties, the firm is manually checking the values are consistent, calling and comparing values as need to reconcile with the counterparty to ultimately reach a conclusion. Using spreadsheets to support these processes and the manual intervention required makes it a laborious process and difficult to scale.
Even with some of these concerns, approximately half respondents have not really completed operational preparation for central clearing to manage these margin call increases. In fact, in our study even the organizations that say they have already prepared for these changes also state that they believe their margin processes are still inefficient and have limitations in existing systems.
Q. Will the mandate to centrally clear OTC derivatives coming up, how will the market change impact the collateral management operations of buy-side firms?
We are still at the early stages of the launch into central clearing and expect the move to take time. Ultimately the bulk of Over-the-Counter (OTC) instruments will be centrally cleared but in the interim there will be a mixed environment, which will require firms to navigate some of the complexities associated with both cleared and non-cleared portfolios.
We expect the cost of the financial industry to be in excess of $53 billion in the next ten years in terms of industry and technology investment which will include upgrading systems, sourcing operational capabilities externally to maintain multiple legacy systems, as well as work required to address some of these inefficiencies on a mixed cleared environment.
Q. Looking ahead to the future, what do respondents plan to focus on when improving collateral management operations including optimization strategies?
There were two themes that emerged when discussing the future view of collateral management with respondents and how they want to improve the operational process.
Firstly, the need for collateral efficiency – to trade and clear in a way that minimizes collateral overhead, is a high priority for firms. Collateral efficiency decisions are moving towards the front-office because a firm needs visibility in terms of where the collateral positions are and how to trade, with what instruments, and where, in order to minimize collateral impact.
The second area cited by respondents was the clear need to achieve operational efficiency with in margin call processing in areas that are either manual or require a lot of resources.
More interestingly, our study is already showing a chasm between the ‘haves’ and ‘yet to haves’. The firms that are actually leading the pack hold higher priorities on efficient margining. They are also on average more equipped to employ a higher proportion of cleared derivatives as part of their portfolio. So, they are less likely to face restrictive changes in the front office when they want to execute collateral efficiency type positions in the front office compared to firms who are less prepared and who are being forced to make trade offs in terms of the degree of hedging, the type of instruments used and also their ability to address challenges in operational activities.
In short, the firms that are ahead in preparation for collateral efficiency are well positioned to succeed in the long term while those falling behind could potentially face significant disadvantages and a long up-hill battle going forward.
Q. How will the impending change in the collateral management operations impact how this operation is resourced?
In the short term and while the technology is being put in place organizations will probably need to be better resourced. In the study itself there seemed to be a trend to move from in-house developed solutions towards third-party platforms or even outsourced solutions for firms that don’t have the internal resources to either build a system or large collateral infrastructure.
Sourcing decisions for collateral infrastructure is dependent on the size of the derivatives book and the requirement to manage margin calls. For some firms, it may come to a certain point that if the organization is sub-scale, it isn’t ideal manage collateral in-house. For smaller firms with a limited scale in terms of trading derivatives or collateral management capability, it probably makes sense to outsource rather than to have an in-house solution or large collateral management team. For other organizations, it will come to a point where to manage the derivatives positions held, these firms will need to do more with the collateral pool available and that is when the investments in more sophisticated IT or infrastructure could take place.
Q. Were there any surprising findings out of the study?
One thing is that there are still a fair proportion of firms that are still unprepared for the coming market environment. In our study, almost half of the firms (48%) are not yet there. Even with intense regulatory and business pressures, Inertia seems to still be prevalent.
Secondly, the industry has been discussing a lot about achieving portfolio margining and netting efficiencies. In our study, a large majority of firms (~45%) are in the dark pertaining to the degree of margin offsets that can be realized. Those which have an opinion only expect 10-30% savings across cleared products. This is in contrast with the high “capital efficiency” headline figures (in excess of 70%) touted in the public domain by large clearinghouses and some analysts. Perhaps the firms in our study have a more realistic view of the world!
Another interesting finding, although not surprising, was that over 90% of the firms said they did daily margining, but at the same time over 20% stated they are struggling with daily margining processes. So there seems to be a contrast between what their ambitions are and how they are delivering on the ground. This wasn’t a surprise but it shows the contrast between firms wanting to do something and actually executing change.
Q. In the long run, how will the derivatives regulatory reform and greater capital requirements change the business and operations for buy-side firms?
About 55% of respondents stated they would need to change the way they hedge and trade as a result of these market reforms, which is of course, tied to the fact that they need to make collateral efficiency decisions when trading.
Even organizations implementing infrastructure to manage and optimize collateral will need to change trading strategies. The distinction lies in whether or not a firm has the infrastructure in place to provide the information the front office requires to make informed decisions about the way it trades for collateral efficiency purposes as opposed to firms who lack this information and will have to impose limits on the way the front office trades. Either way, trading strategies will change but it’s just a question of whether you have the information to make informed decisions rather than being reactive.
Q. Based on your findings, can you offer any advice to buy-side firms?
The first thing I would recommend is to centralize collateral inventory. Then, when the margining process is in place, a firm can start thinking about the collateral efficiency and apply intelligent analysis with the collateral data available to enable the front office to trade and clear in a way that optimizes collateral.
Also, many areas within an organization use collateral information so whatever collateral systems or solutions used must be standardised and open so they can easily connect with other systems to ensure the information is delivered in a timely and efficient manner.
Finally, I think organization should be aware that there are other areas of the margining chain that may pose a high operational risk so they need to look at the breaks in the chain to streamline and automate the entire workflow process. It’s not just about margin management but also enabling portfolio and trade execution decisions in the frontline.
