When it comes to choosing a collateral management solution there are three clear models on offer. Jeff Campbell of Actualize Consulting explains the pros and cons of insourced solutions, outsourced services and cloud-based technology.
In response to regulatory change, competition in the collateral management solution space has changed significantly over the past couple years. Historically, firms seeking collateral management solutions were limited to purchasing vendor products that specialized in collateral management or outsourcing the function to a third party (i.e. custodian), which provided services focused on margin and settlement management. The market is witnessing an explosion in new vendors and outsourcing providers in the collateral management space, as well as a third option; cloud-based “front-to-back software”. Each of the three options provides robust functionality and configurable solutions to their clients. However, firms have unique operational requirements and should fully analyze their holistic collateral management, asset utilization and clearing needs before deciding which of the three aforementioned options is best for them.
Historically, end-users operated in a bilaterally negotiated collateral arrangement with their broker-dealer counterparts in terms generally acceptable to both parties, especially regarding eligible collateral. These same firms are now placed in a unilateral relationship with initial and variation margin requirements dictated to them by central counterparties (CCPs) plus additional “ramp-up” margin required by the Futures Commission Merchants (FCMs) they utilize to clear their trades. Eligible collateral parameters are significantly more restrictive, with eligibility limited to high quality and liquid assets as well as an increase in haircuts, respective to uncleared bilateral CSAs. With clearing requirements for swaps estimated to increase collateral requirements in the trillions (as released by Tabb Group in March), end-users are quickly moving off risky spreadsheets and seeking solutions to best manage their collateral and derivative exposure.
Collateral management solutions now expand beyond the bilateral (pre-Lehman) collateral management model to address the new regulatory landscape. Vendors who have historically competed in this space have adapted and enhanced their products to provide more comprehensive solutions, whether it be FCM/CCP connectivity through AcadiaSoft or SWIFT, automated reconciliation uplinks to other third party providers, or providing collateral optimization modules and algorithms as an added feature to their base products. Outsourcing and cloud-based solutions are offering new products and services from collateral hubs and highways, to optimization modules, to cheapest to deliver calculations. Regardless of the chosen path, there are immense options and choices for firms seeking to address regulatory requirements and mitigate clearing and collateral management operational risks.
Insourcing
For traditionalists, insourcing a vendor application will address collateral management-related operational issues. These “out of the box” solutions have proven track records and are configurable to a firm’s specifications. Their in-house subject matter and technical expertise make an implementation more seamless and provide their clients with the necessary tools to navigate the regulatory landscape. Vendors also bear the responsibility of understanding ongoing regulatory change and ensuring their products fluidly and accurately provide the necessary workflow and controls to proactively mitigate risk for their customers. Vendors have utilized their expertise and built upon their solid collateral management solutions and expanded beyond the bilateral collateral management model. Their offerings provide functionality ranging from the ability to manage collateral cross-product, manage cleared vs. non-cleared simultaneously, Swap Data Repository (SDR) reporting tools, and collateral optimization functionality, just to name a few. Utilizing these comprehensive products can address any collateral management regulation a firm may face, and help minimize bifurcation while helping lower costs associated with clearing and collateral management over the long term.
“Utilizing a vendor solution to support your collateral management allows you to enjoy the best of both worlds. You get to leverage the global expertise of your partner provider to ensure your technology is current with latest functionality while still retaining control of the collateral management and process; more specifically you control when calls are made and what collateral is utilized. “ states Ted Leveroni, Executive Director of Derivative Strategy and External Relations, Omgeo, LLC.
Utilizing mature vendor applications with immense functionality introduces a significant amount of responsibility and cost. These applications often require a large technical footprint and ongoing maintenance from internal technology resources. When coupled with day-to-day operational support, costs can quickly escalate. Additionally, as the arms race will likely continue in response to ongoing regulatory change, vendors will continue to enhance their products and end-users will need to invest financial and personnel resources to support their burgeoning systems and properly test and support product updates and enhancements. Secondly, robust and flexible collateral management products incur a high initial cash outlay due to license fees and firms may be paying for functionality they don’t necessarily need or utilize. As these products generally cannot be parsed by functionality, firms with less complex collateral management processes may pay a premium for a robust vendor application.
Outsourcing
When vendor applications are measured against outsourcing, it is easy to see why outsourcing a firm’s collateral management operation has gained significant traction. First, firms generally don’t encounter large initial cash outlay as costs are generally more static and distributed month-to-month. Second, unlike large vendor applications, end-users only pay for services they require. Third, outsourcing allows a firm to significantly decrease headcount, despite collateral management growing in complexity, and operational “headaches” can be managed by a provider that keeps up to date with regulatory requirements on a firm’s behalf. Lastly, custodians and other outsourcing providers have access to billions in high quality and liquid assets and can more easily provide liquidity and collateral transformation services to their clients. Custodians provide the required in-house expertise as well as the pipes and connections to more easily and perhaps less expensively manage a firm’s collateral and margin requirements. For firms that choose not to invest resources and capital to internally manage a collateral operation, entrusting their custodian or another provider is a great solution.
“Due to regulatory reform and market best practice guidelines, collateral management is becoming more complex for firms to manage operationally. Historically, there was no need for collateralization or it was done manually in silos. That approach is no longer sustainable in the current environment. With the constantly evolving regulations and the complexity of new margin requirements it is necessary for a firm to have a full view of their exposures, collateral positions and asset inventory. This will allow for more efficient use of collateral through the optimization process and immediately address any shortfall issues that may occur through transformation. When partnering with the optimal service provider, outsourcing collateral management services eliminates the operational burden to allow firms to focus more on trading strategies and other profit center activities. The breadth of knowledge and real world experience at the ideal provider is invaluable when breaking down silos and building a holistic, automated collateral management solution” says Joseph Streeter, Vice President and Collateral Product Manager at State Street.
However, like with vendors, this comes at a cost. Generally arranged in an “a la carte” fee-based structure, these fees can cumulatively match and/or exceed what is charged by vendors for their products. Another cost to consider is relinquishing the ability to oversee the collateral management process. While outsourcing certainly lessens a firm’s operational workload and headcount, it may encourage firms to be laissez faire regarding the day-to-day as well as ongoing regulation changes and updates. This approach makes it increasingly difficult to ensure custodians are efficiently and effectively managing a firm’s collateral. Firms should heavily consider developing internal oversight tools and processes and actively monitor their outsourcing provider as well as their use of collateral and margin activity on a day-to-day basis.
Additionally, all firms must now post initial margin for every cleared trade. If collateral management is outsourced to a third party, it introduces a disconnect between your firm’s trading and collateral management functions. Traders need to look beyond the spread when determining to trade and determine the overall cost of each transaction. That cost includes not only the fees FCMs and CCPs charge, but also what collateral is cheapest to post for that particular trade. As eligible collateral expands beyond cash and Treasuries to less liquid instruments like corporates, disparate haircuts charged by the CCPs based on collateral used as initial margin can influence that cost. In some cases, it might be possible to book a new trade that will net against a firm’s portfolio and provide a net reduction in initial margin that will need to be posted to the CCP. To appropriately analyze and calculate the cost of a trade, firms will need to have their collateral data ring-fenced, available in real-time, and readily accessible to their traders. Firms should also possess an internal source with the expertise to make a determination at execution as to what collateral should be utilized. If the trading vs collateral “disconnect” is not properly addressed, firms run the risk of not posting the right collateral to the right place at the right time, and can introduce additional fees, penalties and operational involvement, specifically through collateral transformation services provided by the outsourcing provider or on a firm’s repo desk to properly fund collateral shortfalls. Collateral transformation is a valuable component of any outsourcing offering, however, if internal controls around trading and proper use of initial margin collateral are not properly implemented, escalating transformation and funding costs could exceed the benefit of outsourcing collateral management to a third-party provider.
Cloud-Based Technology
The happy medium between insourcing and outsourcing may be utilizing cloud-based technology. Most of the new vendors in the collateral management space fall into this category. These vendors provide clients the control they require to manage risk, but implementations are generally quicker and require less strain on technology resources. These solutions generally come with a lower price tag than the two aforementioned options and pricing structure may be more flexible and avoid agreement tiering or transactional-based pricing. These vendors are quickly trying to obtain market share and stress their products ongoing development as partnerships with their clients. These solutions also tend to not be strictly collateral management solutions. Many are designed to be more comprehensive and model themselves as “front-to-back” solutions specifically aimed at buy-side entities. These solutions will provide basic collateral management functionality and help bridge the gap between collateral and trading via tools such as robust collateral optimization functionality, cost of trade calculations and real-time connectivity to FCMs.
“Cloud deployed solutions have interesting advantages for problems such as collateral management domains which must adhere to fast moving regulatory changes. While cloud solutions don’t fit the needs of firms reluctant to trade-off full control versus ease of maintenance, cloud solutions can be very agile and offer a rapid deployment model adaptable to fast moving requirements. From a technology perspective certain products, real-time aggregation engines are agnostic to where they are run, especially if there are centralized pricing feeds or reference data sources housed within the cloud based collateral solution. In that case the appeal of a cloud offering can bring cost effective economies of scale” says Allen Whipple, Founder and Managing Director at Quartet FS.
However, many of these vendors and products are new to the market and less proven than their counterparts. These providers could be less financially secure, which could affect the product’s integrity over the long-term. Next, while these products are generally more comprehensive over the entire trade lifecycle, they often lack the nuance of sophisticated collateral management processes and other niche workflow requirements. For firms that do not have “plain vanilla” collateral management, these newer products could introduce too many workflow and functionality gaps, and thus new risks by incorporating into a firm’s daily workflow. Their depth and breadth of active clients might also be significantly less than their traditional vendor counterparts; they simply might not have a requisite product and implementation track records for a firm looking for a more nuanced and pure collateral management platform. However, these vendors are armed with nimble technology and are more than willing to continue developing their products with client recommendations versus a more established product that is less flexible due to size and breadth of functionality and legacy architecture. As collateral management has morphed into more of a front-office function, it gives firms a great opportunity to utilize a solution that marries collateral and trading.
These guidelines are certainly not “one size fits all”. Generally, bigger end-user firms have collateral management expertise in-house, and the cost of a vendor solution is justified to maintain operational oversight and mitigate risk. Smaller end-users will be attracted to outsourcing and allow them to focus on their core competencies. As their collateral management-related volumes may be low, outsourcing providers can be less expensive than developing the internal infrastructure to support the complex processes related to clearing. Lastly, cloud-based technology and their unique “front-to-back” solutions can check off a lot of operational boxes that have not been traditionally available in a collateral management solution. Their light technology will be well-received by firms, but depending on the complexity of a firm’s collateral management operation; a cloud-based solution might not include all the necessary processes and workflow elements.
Regardless of the option (insource/outsource/cloud) a firm pursues, each firm must gravitate down an operational path that can wholly support real-time margining in lockstep with daily trading activities and CCP settlement requirements. End users must arm themselves with the access and tools to manage and properly utilize high quality and liquid assets. This requires firms to equip themselves with expertise and nimble data systems to deftly navigate operational landmines and minimize long-term costs. Choose wisely.
