Following the financial crisis, collateral management was centre stage for market participants who found themselves working to comply with new regulatory requirements, which generally called for greater collateralisation of OTC derivatives – both cleared and uncleared. Two trends that were expected to be big game changers at the time were collateral optimisation and collateral transformation. Ten years on we explore how these two trends evolved but not necessarily as anticipated. Industry experts from Barclays, Citi, DTCC-Euroclear GlobalCollateral Ltd and InteDelta share their views.
Collateral Optimisation – Expectations Then and Reality Now
In the aftermath of the financial crisis, regulators across the globe sought to create a safer market place for investors by reducing counterparty credit risk and mitigating widespread contagion risk upon an entity’s default. In order to reduce these risks they passed rules mandating the clearing of certain OTC derivatives, the exchange of variation and initial margin for bilaterally traded derivatives and MTM margin and maintenance margin for Agency MBS transactions. As these rules took shape, many potential trends and market behavioral shifts were contemplated by market participants including the squeeze on high quality liquid assets (“HQLA”) and the need for market participants to actively engage in collateral transformation.
We are now coming upon the ten year anniversary of the crisis and many are taking a rearview look and asking why these trends never materialized to the extent that was contemplated. In order to address this question it is important to take a step back and look at a variety of market factors.
Firstly, as market experts contemplated a squeeze on HQLA and the need for transformation they assumed that regulations were completely phased in and implemented. While many of the reforms have gone into effect some aspects of the rules, such as the initial margin components of the margin requirements for non-centrally cleared derivatives, have a couple of years before all impacted market participants come into scope. In fact, the vast majority of market participants will not actually be impacted until September 1, 2020.
Secondly, since the financial crisis, interest rate levels have been at an all-time record low. As a result, many market participants have opted to post cash to meet their margin call requirements as it has been fairly inexpensive to do so. As quantitative easing policies change and interest rates potential rise, market participants will have greater incentive to identify alternative collateral strategies that mitigate any collateral drag on their fund performance. This may include leveraging collateral transformation strategies such as lending out hard to borrow assets for the cash to meet their requirements.
Lastly, while many of the rules were deployed in line with initial expectations, many rules were tweaked and refined throughout the rule making process and commentary periods as regulators sought to seek a balance between cost and benefit. For example, clearing was never mandated for non-deliverable forwards and certain FX products were not included in the margining requirements for non-centrally cleared derivatives. As a result, the demand on HQLA has not been as high as initially anticipated and certain fund types have been eliminated from the scope of the rules and therefore no longer need to seek collateral transformation services.
“Although it is ten years later, it may still be too early to determine whether trends such as a squeeze on HQLA and collateral transformation will materialize to the extent anticipated. While some events have decreased the potential demand on collateral assets permanently, other components are being phased in and are expected to have a more profound impact in the future.“
Although it is ten years later, it may still be too early to determine whether trends such as a squeeze on HQLA and collateral transformation will materialize to the extent anticipated. While some events have decreased the potential demand on collateral assets permanently, other components are being phased in and are expected to have a more profound impact in the future.
Although there were predictions soon after the financial crisis that collateral optimization would quickly take flight, we have not observed as much of the market deploy such tactics to-date, especially with buy-side market participants.
However, there are mini-trends that are supporting infrastructure changes which will further drive collateral optimization including resourcing, streamlined processing and data standardization.
First, we are seeing more firms who previously had siloed operations among multiple derivative types and between front, middle, and back offices come together with holistic operations. No longer is a rates or futures trader simply looking at bid/ask spread, but working with their front office to determine the most efficient hedge considering execution and collateral costs with counterparty and liquidity risks. With the increased need for collateral, and regulatory requirements for OTC cleared and uncleared swaps variation margin and initial margin, the middle and back offices can not simply use a list of treasuries or post cash, instead they need to be in constant contact with their front office to use the most efficient collateral available.
Secondly, margin call calculations and agreements, affirmation of margin to be delivered/received, and collateral settlements are all becoming much more streamlined, starting with OTC bilateral derivatives and industry efforts to take those efficiencies across Repos, TBAs, and ETDs/OTC cleared. Buy-side firms are abandoning their spreadsheets and emails for robust collateral management systems that have automated messaging capability. These improvements are driven by market participants implementing utilities for processing and using the tri-party collateral model to efficiently value, select/optimize and settle collateral.
Lastly, confirmation of settlement and position reporting data standardization will allow for firms to more quickly ingest the necessary data to better optimize collateral in real-time.
“Those who first predicted big changes to occur in collateral management post the financial crisis didn’t have other regulatory requirements in their crystal ball perspective which pulled resources away from these infrastructure improvements.“
Those who first predicted big changes to occur in collateral management post the financial crisis didn’t have other regulatory requirements in their crystal ball perspective which pulled resources away from these infrastructure improvements. Plus due to low interest rates, cash has continued to be the cheapest and easiest to deliver for collateral. However, with interest rates rising in some global markets, the ‘easiest to deliver’ collateral management strategy may soon be replaced with the ‘cheapest to deliver’ from a capital and liquidity perspective.
DTCC-Euroclear Global Collateral Ltd (GlobalCollateral) has recognized these trends and have worked with the industry to build solutions that can support collateral optimization. The Margin Transit Utility (MTU) processes collateral settlements with connectivity to buy-side and sell-side firms and both custodians and triparty providers with real-time updates, exception and fail notifications, and end of day standardized position reporting. The Collateral Management Utility (CMU) provides globalization of collateral assets from DTC to Euroclear via the Inventory Management Service (IMS) and also efficient means to deliver cheapest and easiest to deliver collateral with the Collateral Management Service (CMS) which can value collateral posted, optimize collateral to be delivered based on eligible collateral schedules and rules-based algorithms, and then settle with the receiver’s triparty provider or custodian.
We have seen a steady uptake of collateral optimisation implementation amongst our clients, certainly over the last 5 years, although the broad thrust of the question (that this trend has not been as rapid as many commentators originally expected) is a fair one.
Where we see the industry as being at right now is that collateral optimisation is a fairly well embedded function within the front offices of most large and many medium sized banks. This was not the case 7 or 8 years ago. It has not yet, though, fed down the food chain to smaller banks and asset managers in a widespread fashion. To a certain extent, this simply reflects the regulatory timelines – particularly for the most material collateral burden which is the uncleared initial margin requirements. The large banks have been hit with this first and so have had to react to mitigate the impact the earliest.
“The more fundamental question challenging smaller firms though is, even once these regulations do come through, what is the business case for implementing collateral optimisation?”
The more fundamental question challenging smaller firms though is, even once these regulations do come through, what is the business case for implementing collateral optimisation?
The experience of the large and medium sized banks is that implementing an efficient collateral optimisation process is not trivial or without cost. The main challenge is not the algorithms themselves but other dependencies such as the integration between front and back office systems; aggregating a timely view of available inventory; and fully automating the operational margining processes. Without these, the benefits of optimisation can’t be achieved.
Set against these costs are the projections of the economic benefits to be gained from optimisation. For many firms these benefits have been difficult to get a clear-cut view on, particularly because low interest rates and the inability to widen eligibility-sets have together constrained the potential economic benefits to be gained. The reversal in the trajectory of global interest rates is likely to change this equation and make the business case for optimisation far easier to make.
With the implementation of uncleared initial margin for smaller firms, a final and important question for many will be to what extent they really need to actively manage their own collateral optimisation, or whether they can just as readily rely upon the triparty agents which they will use for initial margin segregation. For the large banks which optimise across many different collateral demands, relying solely upon a triparty agent for optimisation has not been possible. For smaller players though, which have fewer material collateral demands outside cleared and non-cleared initial margin, this may be a viable option.
Collateral Transformation – not the silver bullet expected
Collateral Transformation allows Financial Institutions to transform less liquid collateral into more liquid assets. For example, for a fee, I may exchange some Asset Backed Securities or Corporate Bonds for some High Quality Liquid Assets, such as gilts. Also termed as a Liquidity Upgrade, this sounds great for Firms who may not have access to liquid assets required to satisfy requirements, CCP Initial Margin for example.
This was billed as a saviour to the Buy Side firms who could be impacted by newly introduced regulations, particularly Pension Funds who historically may not have had access to reserves of cash for margin and rely on long dated securities to support long term liabilities paid out to Clients.
However in times of stress (the times collateral is generally needed), demand for HQLA obviously increases and we all know what happens when Demand goes up, especially where there is a finite supply:
Fees will go up potentially leading to those Buy Side firms having to sell off ineligible assets to raise enough cash to pay those fees. This would lead to a surplus supply, driving down the price of those ineligible assets, meaning more would have to be sold off to raise the necessary cash and in turn depleting your balance sheet. Not a good place to be for that Pension Fund to be in…
Even in times of relative stability the cost of transformation may outweigh the necessity; this market of ever changing regulatory requirements means that all firms are becoming more cost conscious. The cost of converting assets to cash (or other liquid collateral) can require large outflows of cash to fund… Should I pursue a practice of spending cash on fees required for transformation in order to supply cash as collateral, or should I use the cash I already have as collateral?
Even if market stress and fees were not an issue, the operational overhead required to ensure the coupon from the transformed bonds is delivered to the rightful owner would be large; the act of monitoring coupon payments and processing substitutions prior to coupon could take up a lot of resource.
“… Collateral Transformation hasn’t been the silver bullet originally touted and firms tend to optimise their assets more effectively meaning improved access to liquidity.”
As a result, Collateral Transformation hasn’t been the silver bullet originally touted and firms tend to optimise their assets more effectively meaning improved access to liquidity.
While it may not be suitable for everyone, one Collateral Transformation (or liquidity upgrade) facility that does (in theory) work is the Bank of England Discount Window Facility. Loosely based on the Special Liquidity Scheme used during the crisis, the BoE review the liquidity & viability of eligible institutions prior to approval. Participating institutions are required to have a pre-positioned collateral account made up of eligible, illiquid assets. When required, possibly during a Liquidity Shock event, the participant is able to exchange the value of the prepositioned collateral account for liquid assets, such as gilts. This is a short-term fix for liquidity issues rather than a solution, i.e. it doesn’t support the ‘Too Big To Fail’ ethos of the crisis.
Overall it seems that rather than increase availability of liquid assets which as initially touted, the mechanism required to support Collateral Transformation can reduce liquidity and increase costs, in an already costly market.
We ultimately find it positive that the slower than originally anticipated regulatory timelines for initial margin have allowed the collateral optimisation industry to steadily develop and mature in a controlled way. Best practices have emerged, and we expect these to feed down to smaller firms. The extent to which they implement these internally or via external agents will undoubtedly differ depending upon the overall dynamics and economics of each individual firm, but we expect the implementation trend to continue over the next 5 years.
Related Reading: “Ten Years on: Are Derivatives Markets Safer?”
