In a Q&A, Murex’s Etienne Ravex explains how both buy-side and sell-side firms should approach collateral optimization to ensure they are maximizing what they have and adopting all techniques available in the new OTC derivatives space.
Q. What does collateral optimization mean and why do the buy side and the sell side have different plans?
A. One of the trickiest aspects of collateral optimization is defining what it is. Pre trade, the front office needs to account for the cost of collateral before trading—to minimize the initial margin (IM) impact of a trade by arbitraging between the different clearing venues, or even to arbitrage between cleared non-cleared derivatives and futurized swaps.
Post-trade, the idea is to find the most efficient allocation of assets within a predefined set of constraints—eligibility, cost, cheapest to deliver collateral, corporate actions, currency, location and custody fees—to determine the cheapest way to deliver assets for a given agreement and a given protocol.
There will be multiple optimization targets and optimization policy will differ from firm to firm. Firms may need to smooth their liquidity profile typically by using a liquidity coverage ratio (LCR) ratio as the optimization target. Or they may look to rebalance the collateral assets that are held in place to enhance and rebalance the capital structure of the bank to account for constraints on Basel III Level 1 assets. Or, more commonly, firms will adjust the assets pledged or held, based on over-night funding and CCP rates.
Buy-side and sell-side firms may have different ways to approach this. Historically, the buy side is less constrained than the sell side with regards to capital requirements and liquidity ratios. However, as one can never bet on a never-ending cheap funding environment, we’re starting to see a lot of convergence between sell side and buy side optimization plans.
To summarize: collateral optimization requires the proper pricing of derivatives to include collateral cost; a pricing consistent all along the chain from front-office to risk & middle office, followed by the use of arbitrage capabilities on execution venues to reduce the IM requirement at the time of execution; and then the ability to make the best use of available and eligible assets within the firm to satisfy the margin requirements; along with the capabilities to process and settle them.
Firms may put a different level of focus on each of these aspects. However, it is interesting to note that front-office, risk and back-office concerns are becoming intrinsically linked, changing both the way practitioners approach the problem, as well as their expectations from a collateral management system.
Q. What strategies can firms follow to achieve best use of collateral?
A. This might seem trivial, but firms must first ensure they have properly digitalized collateral agreement terms and schedules, to have a correct overview of the eligibility terms at stake—working from PDF documents makes things very difficult. Second, they must achieve a high rate of straight-through processing (STP) in their daily operations. This will enable them to cope with the increasing number of calls to execute, as well as ensure the ability to execute on opportunities for optimization.
Firms need to understand the different collateral segregation models and optimize between locations (US CCPs vs European CCPs). They need to avoid over-collateralizing, by identifying the exact amount of collateral required for a given trade. It is also important to keep the collateral active, to avoid having idle collateral assets—typically by leveraging on substitution rules and borrowing assets.
Possibly the trickiest area is to have a clear governance model over the use of available assets within the firm. This will typically enable firms to set up the constraints driving the optimization process. They must accurately track and manage rehypothecable assets to enable collateral trading. They need a sound and accurate inventory of collateral assets and an inventory of available and eligible assets.
A firm must define its own internal cost structure over encumbered assets, as well as its own specific optimization targets. Then it must implement the algorithm modelling the set of constraints to identify the best collateral available within a given inventory—and back-test it against operational capabilities before execution. Using funding valuation adjustment (FVA) for cleared trades and credit valuation adjustment (CVA) for non-cleared, the firm must then determine the real price of a trade and optimize before the trade takes place—while including LCR impact in all calculations.
Q. How can firms find a balance between operational constraints and the analytical results of an optimization engine?
A. That’s a difficult sweet spot to find. Too many assets will make it too complex to process, too few and some of the optimization benefits cannot be achieved. It’s an iterative process where firms match the back-office processes against outcomes. Alongside manual single and multi-factor algorithms, firms should conduct a series of what if scenarios to find the best use of assets.
Centralizing the inventory is critical in order to optimize post-trade collateral, as is selecting the right level of aggregation (e.g. geographies / business lines).
Operational constraints such as the settlement fee, the maximum number of substitutions, and maximum number of assets within a margin call, will be the typical inputs into the optimization engine.
Firms will benefit from market structure reform such as Target2Securities (T2S), which will impact the velocity with which collateral assets can be exchanged. Firms will have greater access to their assets, and assets that were previously locked will become available for use as collateral.
Q. What is a short-term change a firm should make now to support more efficient use of assets as collateral?
A. If the firm is still cash-centric, and its agreement allows it to, it should deploy the means to diversify the collateral nature to securities. This may seem trivial, but according to ISDA, 80 per cent of collateral issued is currently cash-based. Next, centralize the collateral information, includes known fails, corporate action schedule and settlement delays per custodian to benefit from the increased velocity that T2S brings. The firm should also ensure that they are never over-collateralized, and that no assets are left idle. If they have not done so they should engage in ISDA 2014 Negative Rate protocol, to avoid a punitive situation under negative rates. Finally, firms should implement a simple algorithm (e.g. haircut-based) to identify and allocate the cheapest way to deliver collateral.
Q. What organizational changes can firms make to better support optimization plans?
A. There is no perfect, one-size-fits-all solution that will work for every firm. Still, there are trends, which are worth highlighting. Firms must kill the siloed technology—eliminate business and geographic silos that prevent collateral pooling and netting across one bank. They should centralize the collateral function, linking between the back office—to ensure collateral is overlooked independently of its source (OTC, Cleared, Listed derivatives)—and the front office, ideally with a dedicated trading desk. Having one single point of oversight over all business lines is of great value.
Q. What role does technology play in supporting optimization strategies?
A. Technology has a critical role to play. Technology enables all the operations and connectivity aspects needed to actually execute collateral optimization—such as the automation of re-allocation and substitution. It helps firms avoid derived settlement risk, and ensure sequential settlement during substitution. Technology delivers real-time centralized information, which is key to success. Firms use increasingly complex algorithms and ‘what if’ scenarios. Hence at the end of the day technology is needed to
- – deliver operational streamlining
- – enable pooling of asset within a centralized inventory
- – manage the numerical complexity of pre-trade optimization.
- – make these data available at low IT infrastructure cost
Q. What are the benefits firms can expect to achieve through optimizing collateral? Is there a competitive advantage?
A. They can expect to realize cost benefits, by reducing the cost of immobilized assets and reducing fees. They can also expect increased revenues—better-managed collateral means more capital is available to support the business activities. This means higher volumes and higher income. This could also be seen as a potential new business centre because the collateral chain could then be serviced to clients.
Q. What is the most common question you get from clients on the topic of collateral optimizations?
A. Where to start. That is, which type of optimization will bring me the most benefit? And how can we quantify the benefits?
* To hear more from Etienne Ravex and others on this topic please watch the webinar: “Collateral Optimization: Techniques for Pre & Post-Trade“
