Lynn Strongin Dodds looks at how different providers are leveraging the new collateral management world to win and retain clients.
Although there are still loose ends to be tied, a new collateral paradigm is already taking shape. The wide spread shortages have not occurred but the industry in Europe is gearing up to face the regulatory music. Despite the challenges, the changing landscape presents new revenue streams and sell-side firms, custodians and market infrastructure players have already started to jostle for position.
Until recently, buy-side firms have been slow to come to the collateral management table mainly because some of the regulations have been a moving target of deadlines. This is particularly true in Europe where the mandatory clearing finishing line under the European Market Infrastructure Regulation (EMIR) was changed to December 2015 from 2014. In addition, European pension plans have an additional two-year grace period—and possibly a third year—which could push out their timeline until mid-2018 or 2019.
The other reason for the hesitancy has been the uncertainty over the Bank for Settlements and International Organisation of Securities Commissions’ (BIS/IOSCO) existing proposals for initial margin requirements applied to non-cleared derivatives. As it stands, the rules suggest an €8bn threshold be applied to the regulations when they are phased in fully in 2019. The exemptions would cover those trading less than €8bn notional in OTC derivatives at year end although pension funds, asset managers and lobby groups are joining forces calling for all pension funds to be exempt in full.
Technically, buy-side firms do not have to start their collateral engines until August 2015 but many are expected to begin their journey much earlier. It will not be an easy road. Their sell-side counterparts are well versed in collateral management due to their repo and securities lending practices but pension funds have had a much less sophisticated approach because their collateral obligations were fewer and they often had the high quality assets in reserve.
EMIR and Dodd Frank in the US are forcing them to post higher initial margins for all OTC transactions as well as multiple daily variation margin calls to central counterparties (CCP). In the bi-lateral space, initial margin was rarely requested while custodians typically handled the variation margin – the amount of collateral required to cover changes in an instrument’s value – directly with the end-client.
The preferred route for many buy-side firms will be to hand this seemingly daunting task to a third party. This is borne out by a recent study conducted by Sapient Global Markets, a provider of business and technology services for capital and commodity markets. Its 2014 Collateral Survey showed that 43% of the 40 buy-side firms canvased are currently using an external collateral manager but 70% are considering outsourcing as a collateral management strategy.
“Many buy-side firms are looking to outsource this function because collateral management has become much more complex and custodians are seeing a greater demand for this service,” says Neil Wright, an industry advisor to Sapient. “In the past, a couple of people were assigned to the function and it was mainly done on spreadsheets. This model can no longer be sustained as the process has to become much more automated given the complexity.”
The buy side will be spoilt for choice as there are many providers who are more than willing to lend a helping hand. This not only cements existing relationships but also enables them to mine new potential sources of revenue streams. Asset servicing firms such as Citi, JP Morgan, State Street, Société Générale (SGSS) and BNY Mellon have been among those at the forefront honing and developing their range of collateral management tools. Service levels and products may differ but the main focus is offering inventory, data and risk management as well as reporting and analytical tools.
Collateral optimisation which involves developing algorithms to generate more efficient allocation recommendations to meet relevant deadlines has also come to the fore. These services include taking into account daily pre-agreed obligations, any intra-day changes and calls for collateral and forward-looking analysis and projections, according to a report by the Bank for International Settlements.
Stephen Bruel, vice president and head of derivatives product management globally at Brown Brothers Harriman, adds, “There is a wide spectrum of preparedness among the buy-side because the European mandate to clear is not expected until 2015 and 2016. However, we are seeing a greater desire to outsource because of the costs involved in terms of optimisation technology, customisation and reporting tools. Buy-side firms also want to be able to focus on their core competencies, such as portfolio management. Interestingly, we are also finding greater involvement by the front office; this had not been the case in the past but now fund managers want to better understand the collateral implications when making trading decisions.”
Kelly Mathieson, global head of collateral management at JP Morgan, adds, “We are also seeing more clients focus on how they manage the collateral at the moment of the trade. “They are now having a dialogue with the front office in terms of the economic and physical impact when trading. There is also a greater focus on optimisation which means fund managers are looking at the assets they have, where they are located, what can be used and re-hypothecated and the value before transformation. The bulk of our clients have a sufficient amount of assets to meet collateral obligations, but they are not necessarily in a usable location at the right time, and may need to transform them.”
Clement Phelipeau, product manager, derivatives & collateral management Services at SGSS, also believes that clients will need a strong administrative process and holistic view of their collateral. “It is important that they have a central and aggregate view across all their assets whether it be for listed or OTC derivatives or securities lending and repo. This is because on a global basis they will need to be able to access and locate their collateral in a timely and efficient manner.”
John Southgate, head of derivatives and collateral product management in Europe, Middle East and Africa at Northern Trust, also believes that clients are looking for a more holistic approach. “Clients want to use their existing collateral as efficiently as possible. We are helping them optimise by breaking down their silos and giving them an enterprise view of their collateral. This can help them identify where they have shortfalls in high quality liquid assets.”
Although optimisation will take care of most firm’s requirements, there are still gaps in the product. “At the moment, buy-side firms are not paying enough attention to pre-trade optimisation of collateral,” says Wright. “The margin that firms will need to post for cleared derivatives trades is based on their existing portfolio with a specific clearing broker. This includes any netting opportunities as well as the requirements of the clearing houses and I think there should be a greater focus on this.”
The one product offering that has slipped down the agenda is collateral transformation, which converts lower quality instruments into acceptable higher grade assets via securities lending or repo. This marks a sharp contrast to three years ago when it was one of the key buzzwords. Cost is one reason but also the widely predicted collateral shortfall which ranged between $500m to $6bn has not yet materialised. This is mainly due to the massive bank deleveraging that has taken place which has led to a dramatic drop in the quantity of collateral assets needed. In addition the supply of high-rated paper has grown significantly. Although around $3 trn of government securities have lost their safe-haven status since 2007, new issues of sovereign paper in the same period are well in excess of $15 trine.
The scenario is likely to change in the future although few believe it will be as drastic as predicted. “Today around 80% of collateral is in cash because of the low interest rates,” says Phelipeau. “This means that the buy-side can access liquid collateral more or less easily. We think that there will be relative scarcity in high grade securities in the future because investors will try to be reluctant to post them due to the higher returns. However, I do not think we are facing the big bang that was indicated in some of the studies.”
“There was a debate a couple of years ago as to whether there would be sufficient collateral around, “ says Jo Van de Velde, managing director and head of product management at Euroclear. “There were so many different numbers being published but today people accept that there is sufficient collateral in the marketplace. The challenge is to have the infrastructure that can mobilise it in the most efficient way. For example, clients with collateral in Italy want to ensure there is the infrastructure to allow them to pledge it in Germany.”
Euroclear and the other central securities depository, US’s Depository Trust and Clearing Corp (DTCC) are stepping into the breach to offer complementary offerings. They have recently joined forces to create DTCC-Euroclear Global Collateral Ltd. The aim is to deliver straight-through margin processing and to efficiently pool and allocate the collateral held by both depositories against exposures globally. The first stage will be the Margin Transit Utility (MTU), that will provide straight-through processing (STP) of margin obligation settlement, using existing DTCC infrastructure, by end of 2015, beginning of 2016. The will be a Collateral Management Utility (CMU) that will use Euroclear’s Collateral Highway.
We had been in discussions for a year and half with Euroclear to develop products and address the challenges,” says Mark Jennis. “There are a lot of synergies with broker/dealers, administrators and custodians. To date, the MTU is one of a kind and enables a broad spectrum of industry participants to meet the challenges of increased margin calls. It will offer STP, including the receipt of matched margin calls, the creation, enrichment and transmission of settlement messages to various settlement providers and the real-time reporting and record-keeping of collateral.”
Van de Velde adds, “We believe that by bringing together our combined $75 trn worth of collateral in one pool is a good starting point to address some of the industry’s concerns. The other fact is that our customers and their counterparts are global and they are looking for global solutions in terms of collateral management. We want to give our customers the same operating model to manage collateral across a multitude of locations.”
