Building collateral funding programs is essential for many financial institutions as collateral demands increase with new regulatory change, however, there are risks to consider before establishing funding strategies. Michael Landolfi, managing director, global collateral services at BNY Mellon explores some of these risks and explains also how the front, middle and back-office processes need to change to support a successful collateral funding strategy.
Collateral funding – a cyclical (not a silo) problem
There are a number of risks to bear in mind when starting to look at collateral funding programs but a common and major pitfall many firms sometimes fall into is thinking of collateral funding as a linear or silo problem, when in fact it is really a cyclical problem.
Collateral funding is cyclical process because it requires the close integration of the front, middle and back office. Collateral data is processed throughout the derivatives trade lifecycle, requiring the input from the post-trade operations, before it is then delivered to the front office were the data is used to support execution funding decisions. Thus, when firms start to look at implementing collateral funding programs, they need to think about the potential upstream and downstream impacts these programs might have and how they integrate with the other elements of the derivative life cycle – especially as new regulations come into force and continue to be implemented.
Specifically, silos between products and between front, middle and back office processes need to be integrated. Timeliness is among the key factors that will need to be understood in real time to support collateral funding. In pre-trade, for instance, traders need to be able to understand who their counterparties are, what jurisdictions they fall under, and what the collateral eligibility parameters are. Additionally, a firm needs to be able to assess if they are doing funding activities with their counterparty as well as trading, and if so, what effect does that have on their concentration risks. These are just a few of the many collateral management and counterparty risk-related questions that need to be answered before a trade is completed.
Supporting collateral funding will introduce challenges to the post-trade processes as the middle office needs to ensure it can reconcile trades with counterparties and be able to value and move collateral quickly and efficiently. Also, the back office is responsible for managing how collateral is held and therefore needs to address multiple questions in order to support efficient collateral movements. For example, the back office needs to be able to answer the following questions regarding collateral held: is the collateral being segregated? What role does the central securities depository have in the regulatory environment where the trade is taking place—be it Europe or elsewhere? And what are the trade reporting requirements?
Only those firms with a robust and fully integrated collateral management operation will have the ability to circle back the necessary information to the front office in a timely manner so the traders have the information needed to assess the collateral funding requirements and impact a trade will have on the business. So, clearly a piecemeal approach to collateral funding won’t work as all of these operational processes need to be integrated to support a successful program.
Collateral funding challenges – options for operating in stressed markets
We often hear cost being raised as one of the biggest challenges, and it is very important, but an even bigger challenge with collateral, is knowing what you can sell and how you can sell it. The loss of collateral, or inability to sell collateral, is a significant risk that trumps the cost risk—even though cost remains a significant consideration.
Another challenge for firms is to ensure they have the tools needed to support collateral funding. Firms need to take a broad-based approach, and think about having multiple collateral funding processes. Whether they are using tools already or not, firms should pre-establish them, so that as funding challenges evolve, and cost dynamics change in the marketplace, they can respond accordingly. This is particularly important if the market becomes stressed. Most of the models for collateral processing are built on some version of Value at Risk (VaR), but firms need to understand the wider implications of volatility for their collateral funding processes. For instance, do some sources drive up pricing, or does liquidity dry up in that particular source? Clearly, other factors or scenarios should be considered.
Funding processes can be internal too, of course, and a firm will need to know what the eligible sources for collateral are and what cash it has on hand to use for funding needs. Having this information available allows firms to look at their internal assets and decide whether to go to the repo market for further funding. Firms can look at externally-sourced services, such as lending programs, which may be able to create liquidity for daily margining.
It is very important to look across the multiple avenues for collateral funding and open them all up. This is a very dynamic environment and it will only continue to change and shift. Firms need to make sure that if market circumstances change quickly, they have the legal agreements and process flows in place with their counterparties. They need to have the optionality to make the choices necessary going forward.
It is good to remember that collateral is a two-sided coin. On the one hand there is a cost to use and move collateral, but there is also revenue potential. If there is excess collateral, there is potential revenue that can be generated by leveraging it in different transactions such as repo or securities lending.
Longer-term risks need consideration
In terms of the longer-term risks associated with collateral funding, the big unknown is the interplay of all the different regulations being implemented across the globe. When we talk about challenges with collateral and regulatory reform, we tend to focus on what is happening in the US, or Europe, or Asia Pacific, and with the CFTC and other regulators. However, this is only a small piece of the puzzle within the greater context of global regulatory reform so we also need to take into account all the changes among new regulations including: Dodd-Frank, EMIR, the Financial Transaction Tax, the Volcker Rule, T2S and AIFMD and others. One of the risks that has yet to be defined as these regulations come into play, is how they intersect and how that is going to impact firms.
For example, Basel III introduces additional capital requirements for banks so firms are looking at the capital costs of intraday funding. This is a cost, which they may potentially pass on to their clients, which means banks need to assess if margin movements need to happen earlier or at a different time if the charges are to be passed on to their clients. This is just one example, but there are many more that will come up as these rules and regulations are implemented over the next three to five years.
Understanding the interplay of the many regulations being implemented globally and how all these pieces work together, especially in a volatile market, is a huge challenge now and will continue to be a challenge going forward.
* Hear more from Michael Landolfi and others via the recent webinar (available on demand) on “Managing the Risks of the Derivatives Collateralised Space.”
