Sell-side firms face huge obstacles to bring collateral management processes up to par to meet new regulatory and client requirements, but there are revenue opportunities for those who focus on flexibility and strategy. David Little, director of Strategy and Business Development at Calypso Technology explains in an interview with DerivSource.
Q. Collateral management is a big area of both opportunity and operational burden for sell side firms. In your experience, what is the first step a sell-side firm will take when planning a collateral management strategy.
A. Firstly, most firms are and should take the view that by reducing the operational inefficiencies and costs associated with their collateral management operations, they are also contributing to the profit of the overall business. Collateral management has historically been viewed as a cost centre but this is no longer the case, and in fact, an efficient and automated collateral function creates greater business opportunities for many sell-side firms, including the banks and broker/dealers who offer client clearing services and rely on clearing fees as a main source of revenue. Margin management is an integral part of a client clearing business so the more efficient the operation, the more you can offer your client, the more profitable your business is going to be.
Where a firm starts when tackling inefficiencies in collateral management processes or looking to ensure compliance with new financial regulation tends to differ slightly from one firm to another; however, most kick off with a review of existing collateral operations across the enterprise with the aim to consolidate collateral systems and silos and/or improve the way the traditional back office collateral management functions work together with the front office revenue-generating processes.
Q. Many firms talk about optimisation but is this first priority in reality for most firms as they look to improve collateral management processes?
A. The majority of firms have prioritised centralising collateral operations with collateral silos across the enterprise, which has been a higher priority compared to optimisation strategies. In fact, centralisation is really the first practical step financial institutions have taken even before the organisational overhaul needed to better determine whose responsibility it is to manage collateral and identify, whether the process sits with trading or treasury or in a middle-office function. There is no consensus on this and consequently collateral has ended up in different locations as the owner drives behaviour. With treasury it has often been tied up with funding collateral, whereas if it is in a trading or back office function, collateral management processing is typically independent of funding and considered in conjunction with clearing and bilateral trading.
Once firms gain a full view of their collateral operation, they can then address organisational and system changes accordingly.
Q. What is the biggest operational challenge for brokers offering client-clearing services for cleared derivatives?
A. For many investment banks and brokers offering client clearing services, I think the biggest operational challenge is the ability to support the different asset segregation models the regulators require and customers want, and then to scale those operations and support them efficiently.
A secondary challenge for these firms is the ability to support both cash and non-cash as funding costs of collateral may become more or less attractive. Brokers need to support exchange-traded derivatives (ETD) and Over-the-Counter (OTC) derivatives on a single set of systems so they have the ability to face the client with a single customer statement and view of risk across all of their activities. Offering such a singular and comprehensive statement to a client is a great competitive advantage for client clearing providers. Coping with the new collateral demands will compel the buy side to engage in a thorough evaluation of clearing brokers that will typically be responsible for delivering initial and variation margin on the buy side’s behalf. The buy side must meet their aggregated obligations at the end of each day, either through a credit line or cash buffer they have established with their clearing brokers.
Q. Sharp rises in margin volumes seems to be a worry for most firms. What are the significant changes a sell-side firm can make to achieve the scale needed?
A. The expected increase in margin call volume is definitely a sell side worry and I think it is going to become more prevalent as regulation continues to drive more frequent margin calls as businesses move from weekly or monthly calls. In addition to daily variation margin calls, you have two initial margin calls – each CCP has to give and receive initial margin as well as the segregated margin, which is considerably more collateral activity than before this regulatory initiative. This is a concern for both buy and sell-side firms, and I don’t think all of the costs of the regulatory changes have been passed down to the buy side because sell-side firms are still absorbing those costs and maintaining relationships and building market share. There are considerable winnings to be had for those who can process margin most efficiently but it is not easy due to the complexity of this new derivatives space.
Q. How is the sell side using optimisation algorithms to better identify the assets they can use for margin calls?
A. The use of algorithms is important and will be a growing trend over the next few years especially with sell-side firms. It is less about risk weighted assets and more about the Liquidity Coverage Ratio (LCR) and leverage ratio, so managing the collateral buffers that you have to set aside. Firms need to be aware of the different types of collateral assets they hold and optimise their use across all requirements, including collateral buffers. Algorithms should be considered after other stages of optimisation. When used the algorithm takes what is eligible from the haircuts and different lines of collateral to deliver the cheapest option.
Firms may change the rules by renegotiating Credit Support Annexes (CSAs) in order to better balance the collateral available against the obligations they have to fulfill. A dual approach of renegotiating CSAs for sound risk management and efficient asset allocation and using the algorithm for day-to-day allocation decisions is probably the best way forward.
Firms need the ability to adjust as market and regulatory conditions change because an unexpected market event, such as negative interest rates, can have a huge impact on collateral and most of the current systems are not designed to handle new scenarios such as negative interest rates comfortably or take advantage of them when they occur. For this reason, system flexibility is essential now and going forward especially as the derivatives market continues to evolve.
Q. If a firm already uses the repo market for funding what are the other ways in which they can improve their use of the market and technology available?
A. Collateral transformation for repo traders is a supply and demand situation; clients have needs and they fulfill those funding needs and take a fee for it. Repo traders may participate in the transactions, if not as an intermediary then through asset acquisition, which they use or supply to the market. This strengthens the already strong case for looking at collateral repo and lending as strongly interrelated functions.
At Calypso we go wider than that in that we think of clearing and treasury as part of that mix as well; systems that can comfortably span across treasury funding, repo and collateral management for cleared or bilateral exchange traded or OTC derivatives. Across all of those businesses you need strong, clear up-to-date views on collateral inventory, risk management tools, operational efficiencies, workflow and settlement capabilities. Our customers see the synergies and are gradually expanding to use our solution across the whole spectrum of activity.
Q. Sticking to funding, collateral transformation services seem to still be an offering some banks will offer their clients. How do you see firms approaching this function and adjusting their procedures accordingly?
A. Just to clarify the term first, collateral transformation involves taking existing assets that are eligible as margin and that you have in abundance, and lending them out to other firms who need them to meet margin requirements for both cleared and uncleared derivatives transactions. Some sell-side firms may offer this as part of their general offering and do so for a fee; however, using the cheapest to deliver asset for margin requirements also uses transformation internally for firms who want to reduce their overall costs.
To transform assets, firms need to rely upon information from the collateral management unit and access to the CVA data in order to fully understands the credit terms under which any derivatives agreement is running, how positions are actually collateralised and the potential credit risks. Collateral transformation, or funding for that matter, as part of a wider service offering, is a perfect example of the potential revenue that can be gained through collateral management in the new central clearing environment, but the processes and technology used must be robust, scalable and automated in order to support this service well.
Q. What is the greatest competitive advantage for brokers in the new OTC derivatives space?
A. For competitive edge, sell-side firms must adapt to future regulations and different market conditions quickly and efficiently. If particular types of collateral fail to meet margin calls, firms must be able to adapt quickly to changing market conditions across the clearing business, they should look to include repo, securities lending and funding activities, possibly extending out to treasury.
Firms have to process margin calls both for cleared and non-cleared, optimisation, inventory management, settlement status and analytics such as haircuts. There is a wealth of functional depth and breadth of coverage which firms must keep pace with in order to have a competitive advantage.
Also, with the framework for new margin requirements from BCBS/IOSCO for uncleared derivatives identified, the next wave of compliance changes are expected to top collateral manager’s priority lists in the coming months. And if a firm has already invested in their collateral management operation, adjusting to meet new requirements won’t be so onerous and won’t take away from other plans – potential revenue generating or client facing.
