Collateral management is top of mind for all financial services firms due to the implementation of non-cleared margin regulation. Diana Shapiro, Director, Citi Futures, Clearing and Collateral, discusses emerging collateral models, the various opportunities for collateral optimization, and the provision of collateral transformation services within the ETD/OTC clearing space.
Regulatory changes have brought about a huge shift in the way buy-side firms think about collateral management within their organizations. Front Office, Legal, Compliance, and Risk Management teams are now collaborating to design new collateral strategies. This includes not only looking at cross-product solutions, but also consolidating their collateral activity to enable firms to view all their calls and available assets in a single place. This is the first step towards optimization.
Like many other market structure changes since the financial crisis, regulation has been the primary catalyst for firms to review their collateral management capabilities. Over the past few years, central counterparty clearing has become a reality for OTC derivatives, and many jurisdictions have begun implementing rules to require the collateralization of uncleared bilaterally traded derivatives. Furthermore, in the US, FINRA has amended Rule 4210 (Margin Requirements) (See Securities Exchange Act Release No. 78081 (June 15, 2016) and 81 FR 40364 (June 21, 2016)), to require the collateralization of bilateral “To be Announced” (TBA), specified pool and agency collateralized mortgage obligation (CMO) transactions starting in December of 2017.
While the rules vary from product to product and certain terms may be negotiated bilaterally, these regulations have resulted in an uptick in the number of market participants posting collateral, a surge in the frequency and size of margin call amounts across asset classes, and an increase in the demand on high quality liquid assets (HQLA), such as cash, treasuries and certain sovereign bonds (See Prudential Regulators, Margin and Capital Requirements for Covered Swap Entities, Final Rule, 80 Fed. Reg. 74840 (November 30, 2015)). Collateral management has moved to the forefront as firms explore their operational and technological capabilities to meet these challenging regulatory requirements.
While firms continue to focus on the overhaul of their operational capabilities, market participants continue to face a rising interest rate environment. Firms that historically only used cash as collateral are also starting to think about the potential drag on fund performance and the opportunity costs of holding large cash buffers. Meanwhile, some buy side firms do not have sufficient HQLA to meet their margin calls, particularly during stress scenarios. Thus, it is becoming increasingly important for buy side firms to not only have a streamlined operational process, but also to have a firm-wide collateral strategy to maximize the efficiency of their collateral and optimize the performance of their portfolios.
Three key opportunities for optimization
While buy side firms are establishing their cross functional collateral management strategy, they should consider the three key points in the trade lifecycle that present opportunities for collateral optimization:
- Pre-trade. Firms can evaluate whether to clear an OTC trade or execute bilaterally based on the total cost of ownership. In the new regulatory environment, best bid/offer execution may not necessarily mean best economics for the transacting firm, based on the cost of collateral. Some attributes that may be considered include the expected initial margin requirement, any bid/offer spread differences, the cost of the collateral that is eligible to cover trade exposures, and the interest paid on collateral posted. Firms may also want to look at the cost/benefit of a customized hedge versus a more standardized asset class, such as futures, while recognizing that each product may have different collateral eligibility and margin requirements.For ETD and OTC cleared transactions, buy-side firms should also analyze differences in collateralization and cost per CCP. Each of the clearinghouses has a different initial margin model, and depending on the portfolio, firms could have different margin requirements at different FCMs per clearinghouse. Citi provides its clients with tools to simulate their cleared transaction initial margin requirements across not only the clearinghouses but also across their clearing brokers. As a result, clients can identify the optimal CCP and clearing broker pair from an initial margin perspective.
- Pre- margin call. Clients can optimize their collateral usage by looking at the full spectrum of services their clearing brokers/counterparts are able to offer. In both the bilateral and cleared space, buy-side firms can take advantage of cross-product margin (CPM) solutions, which are offered by CCPs, FCMs and their bilateral trading counterparts. For example, Citi’s Markets business offers CPM, which looks across the full spectrum of a client’s trading activity. While regulatory minimums must be met, it allows for potential margin offsets against other products traded with the firm. In addition, some FCMs offer their clients the ability to cross product margin their Rates and Futures transactions cleared at the same CCP, thus reducing the cleared IM requirement. Other FCM services that may impact a client’s collateral choice are the return that is paid on cash collateral and the ability to support an “LSOC with Excess” model.Like the standard LSOC model, an “LSOC with Excess” offering ensures that the margin posted by one swaps customer of an FCM is legally segregated from the assets of its other swaps customers, and in the case of a simultaneous default of a client and clearing member, the collateral of non-defaulting swaps customer would be removed from the default waterfall and have enhanced protections against fellow customer risk. While the regulatory protections are the same under both models, FCMs that offer “LSOC with Excess” can sweep excess collateral, above the CCP minimum requirement, to the CCP instead of holding assets in an FCM custodial account. The primary benefits of this service are enhanced portability in a double default scenario and reduced day-to-day funding costs. This offering also serves as an option for the reinvestment of excess cash, subject to volume caps implemented by the clearing member.In addition to an “LSOC with Excess” offering, authorized US CCPs are now posting cash collateral to the Federal Reserve, which allows them to earn the interest rate on excess reserves (IOER rate) and pass this enhanced return to the FCMs. While most FCMs take a spread on the interest rate paid, a number of providers, including Citi, offer a full pass through as an option. With the most recent June Fed rate increase, this means that clients can earn over 100bps on their cash collateral that is posted to the CCP as excess and/or to meet their minimum IM requirements. This enhanced yield reduces the potential drag of using cash as collateral. (Note: Actual return passed thru by the FCM will depend on the current prevailing IOER rate and each CCP’s return policy).
- Post call. During this phase of the trade lifecycle, clients may choose to optimize their use of cash versus non-cash assets. A number of factors including regulatory requirements, legal agreement terms, fund composition, investment strategy, operational capabilities, liquidity needs and risk tolerances will impact these decisions. To this end, each firm must have a collateral optimization strategy that spans all groups and asset classes to avoid inconsistencies and maximize efficiencies. That includes looking across both cleared and bilateral activity as well as maintaining a real-time view of collateral inventory. Implementation of these complex strategies will require enhanced analytics spanning the front and back office and seamless operational processing capabilities.For some buy side firms, partnering with third party, collateral management service providers is the optimal solution. These providers can deliver customized solutions that align with the firm’s internal strategies and provide enhanced operational capabilities, collateral optimization, pre and post trade analytics, and access to liquidity. For example, Citi’s collateral management platform provides advanced tools that suit our clients’ needs. Clearly, collateral management capabilities that enable improved portfolio performance via collateral optimization will become a key part of the fund manager’s toolkit in the future.
Who should provide collateral transformation services?
Collateral transformation is becoming increasingly important. Many buy side firms impacted by the cleared and uncleared margin regulations do not typically hold the HQLA required to meet their margin calls, especially in times of stress. For example, an equity fund that engages in share class hedging in Europe may not typically hold cash or treasuries, and therefore may struggle with the Uncleared Margin Rules which require the collateralization of FX forward trade exposures. Similarly, in the OTC/ETD space, some clients are challenged by the requirement to meet variation margin calls in cash. In a worst case scenario, to meet the new requirements, funds will have to liquidate investments to raise cash, which will cause a drag on fund performance. One strategy that can be put in place to mitigate the impact on fund performance is engaging in collateral transformation.
Collateral transformation enables buy side firms to take lower quality, or ineligible collateral and upgrade it into the HQLA that is required to meet their margin calls. This is typically done by firms accessing the secured financing markets either directly or indirectly through an agent. Some have argued that in the cleared OTC/ETD space, it is the clearing members that should provide these transformation services, with clients posting ineligible collateral to the clearing member and then the clearing member lending the collateral out to raise HQLA to post to the CCP.
While in the United States FCMs are allowed to offer these services upon a customer request, once collateral is posted as margin, the FCM runs the risk of running afoul of CFTC Rule 1.25, which specifically states that “securities subject to repurchase agreements must be “highly liquid” (See 17 CFR § 1.25 – Investment of customer funds (a)2(ii)(A) 76 FR 78798, Dec. 19, 2011, as amended at 77 FR 66322, Nov. 2, 2012; 78 FR 68633, Nov. 14, 2013).
When designing a collateral strategy, it will be important for firms to work internally (and in some cases in conjunction with third party providers) to come up with a cross-asset, cross-functional view that also takes into consideration the make-up of their collateral inventory and investment objectives. Failure to act on designing that strategy will potentially become a competitive issue in the future, as collateral can have a direct impact on a fund’s performance.
In addition, under the same rule, FCMs must apply securities that were used for transformation into their asset-based and issuer-based concentration limits, which means that their capacity to accept ineligible collateral for transformation will be capped. Independent of the 1.25 rules, FCMs are required to accept only highly liquid and readily marketable securities from their customers. In some cases this criteria can be more stringent than the universe of acceptable collateral a CCP will accept, further limiting the scope of transformation services an FCM can provide.
Beyond the regulatory complexity of an FCM offering collateral transformation services, there are various balance sheet and capital implications. From a balance sheet perspective, if an FCM is engaging in repurchase agreements, those exposures consume balance sheet capacity at the FCM. Firms have stringent return hurdles for on balance sheet assets, and often the cost of collateral transformation services appears uneconomic for clearing members and clients alike. Likewise, from a capital perspective, under the supplementary leverage ratio (SLR), on balance sheet assets are calculated as part of the total leverage exposure. This total leverage exposure then needs to be covered by Tier 1 capital. Under the US capital framework, globally systemically important banks (G-SIBs) must hold enough Tier 1 capital to ensure a supplementary leverage ratio of at least 5% for covered bank holding companies and 6% for the bank.
As a result of these regulatory, balance sheet, and capital implications, collateral transformation / upgrade services are often uneconomical for clearing members to offer to clients directly. As an alternative, CCPs could look to increase the range of instruments that they deem as acceptable collateral, however, it is likely that an expansion of eligible assets will be subject to very conservative haircuts, and expensive custodial fees. For risk and regulatory reasons, FCMs may also apply more conservative criteria for collateral than the CCP.
In addition, with the implementation of the uncleared margin rules and the overall trend to collateralize trade exposures, it may be more prudent for clients to look cross asset at their transformation and optimization needs as they may encounter similar challenges across their bilateral and cleared positions. As clients look to develop their collateral strategy, some alternative avenues for liquidity access may include leveraging collateral transformation services via other business lines of their clearing member’s firm, partnering with a collateral service provider that incorporates liquidity access and optimization into their offering, tapping into existing repo lines, putting in place agency lending relationships, and/or developing credit lines with banking institutions.
Cross-asset strategies are essential
While there are many directions firms can take to optimize their collateral and realize operational efficiencies, it is important to keep in mind that collateral impacts all levels of an organization. When designing a collateral strategy, it will be important for firms to work internally (and in some cases in conjunction with third party providers) to come up with a cross-asset, cross-functional view that also takes into consideration the make-up of their collateral inventory and investment objectives. Failure to act on designing that strategy will potentially become a competitive issue in the future, as collateral can have a direct impact on a fund’s performance.
Fortunately, compared with a few years ago when collateral management was manually managed via email and/or phone, the collateral landscape has changed quite substantially. There are now numerous tools, as well as sophisticated service providers (including Citi), that provide operational and technological solutions addressing the challenges of collateral management, including collateral analytics, liquidity access and transformation services. As firms develop their strategies, they should explore partnerships in the marketplace to help them find solutions to meet their unique needs.
