The last several years of regulatory change impacting collateral management have paved the way for financial institutions to take their margin operations to the next level – to optimise activities to reduce rising margin costs and generate alpha. In a Q&A with WeMatch’s UK CEO and co-founder, David Raccat, he explores how a cross-asset collateral management strategy and optimisation tools can support collateral trading activities and help a firm future-proof its collateral operations.
Q: What are the market and internal drivers behind the focus on taking collateral management to the next level through optimisation?
A: The collateral management operations for many financial services firms are complicated. Internally firms have multiple silos or pockets of collateral to manage; they are also dealing with the costs of capital optimisation, optimisation of resources, asset allocation, and margin compression as well as various regulatory changes, especially Uncleared Margin Reform (UMR) and Basel III and IV.
The combination of these elements is pushing financial institutions to optimise collateral allocation. Collateral can be in the form of equities, fixed income, ETF, convertible bonds, corporate bonds, Special Purpose Acquisition Companies (SPACS), and mutual funds. There is a large pool of assets that can be used and multiple channels which can be more or less restrictive in what can be delivered as collateral.
The evolution of those internal and external factors has triggered the requirement to implement dedicated collateral trading teams. Historically, collateral allocation was handled by middle or back-office operational teams, but now it has moved to the front office, where traders aim to allocate collateral in the best possible way and even sometimes to generate a revenue stream.
Some firms have now implemented collateral treasury functions that manage collateral on a cross-asset, centralised, and even global, basis. Collateral is moving from an operations mandate towards a front office mandate, where collateral trading forms a dedicated revenue stream for a firm.
“The ability to cover the full spectrum of those listed and OTC products is becoming a must. As these lines become more and more blurred, firms need to be able to optimise collateral on a cross-asset basis.”
Q: What does a cross-asset collateral management operation look like? Why hasn’t this strategy been possible before? How does technology enable this approach?
A: Looking at the securities financing industry, the lines between OTC and listed derivatives are blurring. Clients want to trade the opportunity they have on the market, and more and more are trading both OTC and listed products. Likewise, within OTC, the lines between physical and synthetic products are also blurring. We see traders who trade stock lending, repo, and Total Return Swaps (TRS). They have the ability to trade synthetic and physical derivatives and can then expand their scope into listed derivatives with Total Return Futures (TRFs).
The ability to cover the full spectrum of those listed and OTC products is becoming a must. As these lines become more and more blurred, firms need to be able to optimise collateral on a cross-asset basis. A collateral trader at a tier-one bank needs to be able to look at the potential opportunities across all those products and find the best allocation for any given asset.
Collateral optimisation workflow tools offer the ability to move from one product to another. Depending on the depth of the market, the counterparties available, the exposure they have with the central counterparties (CCPs), or the underlying volatility of any given asset, firms might want to be able to reallocate assets from one pocket of collateral if they are becoming expensive on the repo market, or to identify quickly whether there are some optimisations that can be run.
For example, say a firm has an open, European equities TRS position, and has the ability to reshuffle its collateral on a daily basis. It has delivered some specific stocks and wants to be able to recall those names because they are becoming more expensive to deliver. It wants to get those names back from the swap and lend them out for a high lending fee in order to maximise the return of those assets.
The main driver for a collateral desk is being able to mobilise collateral, have the right level of information and allocate the collateral to its best place. The trader knows the market; the technology provides them with the tools to facilitate the decision-making process and facilitate the workflow with the best information available. The trader knows what is available and how collateral can be optimised based on rules, inventory, requirements, margin calls, exposure, etc. All this information needs to come to the trader in the correct format. The technology also provides the connectivity interface and API interoperability needed to make sure collateral is delivered quickly and efficiently.
“Collateral management is becoming a front-office expertise, driven by both cost saving and revenue generating mandates.”
Q: What are the realistic benefits firms would expect to achieve because of adopting a cross-asset strategy?
A: If firms do not manage collateral efficiently, they will end up with high collateral costs, which will impact the firm’s bottom line. They could end up in a stress situation needing to borrow collateral at a very high cost. This needs to be anticipated, formatted, and framed. Collateral management is becoming a front-office expertise, driven by both cost-saving and revenue-generating mandates.
Another dimension is managing operational risk and reputational risk. Firms do not want to be in a position where they do not have enough collateral in a stress situation and have badly managed their collateral vis-à-vis a CCP or exchange. Failure to have enough collateral to fulfill their counterparty risk requirements can trigger serious reputational issues for a financial institution.
An additional aspect involves how books are marked by internal risk teams. When firms run their books on a mark-to-market basis, internal risk teams need to apply a daily mark-to-market cost to the book, which can depend on the data attached to the value of the collateral they are delivering on the back of derivatives positions. If they do not have the right model in place, or the right data, they might suffer from an adverse impact on their book triggered by their internal listings.
If a firm is delivering a particular stock in a GC basket, for example, and that particular is hard to borrow, they might be hit by dissuasive costs from their internal team, which could ruin the profitability they were expecting on that trade. This is where it helps to have a systematized approach to collateral optimisation with more data to ensure the business controls the way collateral is priced internally.
Integrating collateral trading so it becomes more like a collateral treasury function puts a bank in a better competitive position because any disjunction or segregation between collateral pockets can create immediate friction or costs within the bank. However, depending on the size of the bank, integrating collateral operations across assets and geographies to create a single collateral treasury book can be very complex. Fixed income and equities just do not run under the same system, for example.
Some banks turn to external solutions such as WeMatch to facilitate internal workflows, internal communications, internal matching, or smart allocation of collateral between multiple buckets within the same institution. Some banks prefer a plug-and-play solution rather than transforming their infrastructure in-house.
Q: What can firms focus on next to begin moving to a more holistic collateral management strategy? What advice would you give a firm looking to get started?
A: Firms should start by looking at their existing collateral management framework, how it is managed, who is doing what, and how collateral is allocated. Then they should optimize what they are doing today and make sure they are using collateral in an appropriate way. The more inconsistencies they find and fix, the more efficient their collateral operations will already be.
The next step is to make sure they have the right expertise, the right people and partners to help frame the most efficient setup internally, and the right data and connectivity to ensure they maximise their opportunities.
