By Fabrice Tomenko, head of collateral management/product management at Clearstream, explores how collateral management servicing is changing to meet EMIR requirements.
The environment for market participants is becoming increasingly complex due to regulatory change under EMIR which has resulted from heightened risk awareness since the events of 2008. A combination of this greater focus on risk management practices and new regulation requiring more margin to be pledged for both cleared and uncleared derivatives has pushed collateral management to the top of the financial industry’s agenda.
The technological investments, expertise and general resources necessary to bring collateral management operations up to par with this new market environment are a significant undertaking. It is therefore not surprising that many financial organisations find keeping up with the new regulatory changes time consuming and overwhelming.
When embarking on this collateral management overhaul, financial institutions have two choices: in-house development through system upgrades or outsourced solutions. The complexity of their business needs and the cost are decisive factors for market participants in making this choice.
In-House vs. Serviced: Differences and Considerations
Some market participants may be new to collateral management and may be unfamiliar with the concepts and procedures. They will therefore need to introduce the collateral management functions within their organisation first before focusing on how to meet regulatory requirements. Managing cash as collateral is relatively easy and is a good starting point. However, the process gets more complicated when securities are used as collateral, which will undoubtedly become necessary to support larger and more frequent margin calls for cleared and uncleared derivatives in the near term.
The use of securities, but also the general business needs of the firm in question, will require many to adopt more sophisticated collateral management tools and develop expertise to conduct eligibility and reference checks, cheapest to deliver algorithms and settlement processes for instance.
Investing in a collateral management system to manage these more sophisticated but essential functions is one option but this limits the firm’s ability to pick and choose additional functionalities it may need in future. Investing in in-house systems can also be expensive in terms of license fees, time and necessary resources to implement and integrate the system with other internal procedures such as SWIFT messaging. These costs should not be underestimated, especially as they are added to the normal profit and loss costs.
In comparison, depending on the level of activity, it may be more cost-effective for a market participant to select an outsourced solution to avoid the costs associated with licensing and maintaining the system. Outsourcing generally reduces operating costs over time but also allows a firm to reallocate their manpower to more value-added areas such as dispute resolution and risk management. Firms that opt to outsource collateral management to a service provider will have readymade access to more sophisticated collateral management functionalities such as collateral optimisation algorithms and funding services. Such advanced collateral tools may become increasingly necessary as the market as well as the needs of the organisation evolve.
Costs: Qualitative and Quantitative
Outsourced collateral management solutions bring both qualitative and quantitative cost savings. Many operational managers may currently have team members who are working on the system but lack the expertise to upgrade it to manage the greater volumes and complexity resulting from upcoming regulations. This is a qualitative cost that financial institutions should take into account when setting up their collateral management solutions.
From a quantitative perspective, we expect our customers to reallocate resources which reduces costs by 50 to 70%, even when taking ongoing service fees into account. Furthermore, outsourced collateral management services improve operational efficiency and reduce regulatory costs without sacrificing expertise or the availability of more sophisticated functionalities and tools.
Beyond Basics: Collateral Upgrades and Funding Support
The necessary funding support for collateral upgrades and other services is still completely unknown with some arguing that the extent of the collateral shortage will be clearer once the regulation has been implemented. However, firms have different profiles and liquidity needs so some will be short of collateral and others will be long.
In general, market participants will have to better manage their collateral by ensuring the allocation of collateral to the right place, which is not an easy exercise as collateral is spread over different locations and can be costly if not done efficiently. Collateral allocation is becoming increasingly complicated as firms need to pledge more margins to support both cleared and uncleared derivatives. The advantage of using outsourced services such as TradeCycle is the centralisation of the workflow which reduces collateral fragmentation and enables a more efficient use of collateral and the use of funding services such as tri-party repo, if needed.
Long-term Outlook: Reputation, Partnerships and Flexibility
Market participants can turn to various types of collateral management service providers such as banks, brokers and asset servicing companies. However, the reputation of commercial banks has been damaged by the financial crisis so there is generally less confidence in the ability of commercial banks to manage collateral. As a result, some financial organisations may want to reduce their exposure to these banks.
By comparison, as an International Central Securities Depository (ICSD), Clearstream is a safe service provider with a proven track record and decades of experience in both collateral management and risk management. More specifically, our rate of default is very low compared to a commercial bank.
As we are well aware that our clients are overwhelmed by the scope of regulatory change and need to retain their flexibility, Clearstream teamed up with Commerzbank to cover the full range of required functionalities in a one-stop-shop solution. We can reassure our clients that all their EMIR obligations in the entire trading cycle will be met through TradeCycle, including CCP clearing support, collateral management, trade reporting and advisory services.
I believe the industry is increasingly moving towards partnerships – everyone has their own strengths and weaknesses. In this partnership with Commerzbank for TradeCycle, we have combined the strengths of both organisations, which should increase the liquidity of the product and offer all functions financial institutions require as a single solution.
