In a recent DerivSource webinar moderated by Julia Schieffer industry experts from Calypso, DTCC and PIMCO discuss the emergence of collateral utilities
Greater margin requirements as a result of new financial regulations are driving the increased adoption of collateral utilities in the OTC derivatives markets. Utilities, such as those created through strategic alliances or hub-style outfits—aim to improve operational efficiency and transparency in collateral management processing. However, questions remain around how best to engage with these new entities.
In a recent DerivSource webinar, Collateral Utilities: What Does This Mean For Collateral Managers?, panelists from investment management firm PIMCO, the Depository Trust Clearing Corporation (DTCC) and technology provider Calypso Technology discussed the pros and cons of collateral utilities and what types of processes should and should not be outsourced to them.
Utilities improve operational efficiency
Investment management firms can realize significant efficiencies by outsourcing important but standardized collateral management functions to a utility. Certain processes lend themselves well to being outsourced, such as matching and reconciliations. When it comes to finalising agreements and instructing and settling a firm’s movements, it is estimated as much as 80 to 90 per cent of the work that was previously done manually can now be automated by a utility and presented electronically before the workday starts, saving firms time and allowing them to focus right away on exception handling.
According to the panelists, utilities can speed up the reconciliations process from several hours to a matter of minutes, while also greatly reducing the risk of error. “It’s possible to do reconciliations in house, but if you do them and your counterparty does them, then there is a duplication of effort and you might not have come to the same reconciliation results. Whereas with reconciliation that is done centrally, both parties refer to the single set of reconciliation results. There is an inherent efficiency in that sort of model of operation,” says David Little, managing director, strategy and business development at Calypso Technology.
Utility platforms perform much of the computational heavy lifting that firms are eager not to have to build in house, and it is all done on standardized, regulation-compliant platforms.
What should not be outsourced?
A firm can outsource a good portion of its collateral management processing, but some functions are better kept in house, according to the panelists. Utilities are not equipped to tell a firm what its exposure is, for example. And firms might have proprietary algorithms they do not want to disclose to others—that reveal, for instance, the value they place on certain types of collateral, or include the optimization logic they run to finance collateral calls or re-hypothecate collateral. For these things, using an expert system gives firms greater control than if they were to use a utility, according to the panelists.
Another function that should remain in house is dispute resolution. “Dispute resolution is certainly something that we as investment managers should maintain in house and be extremely involved in,” says Michael Burdian, senior vice president, collateral at PIMCO.
Similarly, firms should not outsource anything that touches on investment decision-making, such as decisions over whether to call in or re-hypothecate collateral, negotiations with counterparties over what constitutes eligible collateral, and decisions about how to finance collateral—whether to sell securities, go to the repo market or net their exposure.
Possible disadvantages
Utilities offer significant advantages with regards to improving operational efficiency, but one major downside is the introduction of a centralized single point of failure. Despite regular testing of the utility’s disaster recovery procedures, firms are inevitably exposed to the possibility of a fault at the utility provider—a risk they did not have with bilateral agreements.
Firms can also lose a certain amount of flexibility when they move to a utility model. Editing fields in spreadsheets becomes a much more drawn-out process, as a utility has to make everything backwards compatible and get agreement on what the new standard will be, which takes time. It is much easier for firms to edit their own spreadsheets and match new fields with their brokers than to wait for a centralized utility to carry out the development. However, the panelists agreed that this downside is outweighed by the ability to know where the firm stands at all times with all brokers—something they do not have in the world of bilateral agreements.
Centralizing IM calculations
With new initial margin (IM) rules due to come into force for bilateral trades next year, firms could benefit from the central calculation of IM that utilities could offer, which will likely be facilitated by the International Swaps and Derivatives Association (ISDA). This would bring the OTC derivatives space closer to the style of operation in the cleared derivatives world, where central counterparties (CCPs) unilaterally calculate the margin amount and call margin, and act as evaluation agent for the collateral, according to Little.
If firms continue to make their own IM calculations, they inevitably have to deal with pricing differences—something that does not happen if IM calculations are centralized. “The advantages of working to an agreed number, even if it doesn’t exactly fit your risk models, will potentially outweigh the disadvantages of having disputes—and especially disputes in public, with an impatient regulator looking over your shoulder,” says Little.
Making a utility successful
No one firm provides the whole end-to-end utility functionality—instead utilities are made up of several collateral management components. It is very important that all these components—collateral management systems, settlement systems, matching engines—are well integrated with each other to form a functioning ecosystem, according to the panelists.
Achieving buy-in can be challenging in the early stages. Early adopters are essential to making utilities a success—although they themselves may not realize all the potential future efficiencies, says Amy Caruso, director, strategy and North America business development at the DTCC. “One of the challenges with a utility is that early first movers may not initially realize all the synergistic efficiencies from the offering. However, as more firms get involved and sign on to the utility, the operational, counterparty, and liquidity risk improvements will be exponentially realized. The initial early adopters that are willing to be involved and be committed to participating are investing time and resources that their firm and others will benefit from the solution in the future.”
Challenges for the industry
In an increasingly complex environment, where firms are having to process more collateral movements each day and with much less tolerance for errors and failures, the main challenges are pulling together all the necessary information in real-time and making sure firms capture all the benefits associated with utilities without losing control and visibility into exposures, collateral movements and inventory. Information needs to be accurate and available to parties both inside the organization (risk managers, liquidity managers, front and back office and collateral operations officers), and outside (regulators and supervisors). Connectivity to the various utilities and counterparties needs to be robust. “What people are demanding of their systems is connectivity to all these good services, updates to keep them in line with regulatory developments and market developments, and integration internally and externally,” says Little.
Looking to the future
With new regulations requiring ever-greater use of collateral, automation of standardized processes is going to be increasingly important. The panelists were enthusiastic on the prospect of collateral utilities.
“I think it will be positive. The industry had been living in a world of uncertainty and manual processing errors …despite the increasing use of collateral. Electronic processing is now possible. I look forward to the day that collateral could be net settled in a zero fail environment. We all are a lot further ahead than we were in 2008; still, we must all keep moving further ahead with automation, because the volume and complexity of the use of collateral have grown exponentially,” says Cynthia Meyn, executive vice president, operations at PIMCO.
Caruso adds: “The introduction of collateral utilities will invite innovation that can be deployed across many firms. With the joint efforts of firms participating in steering groups and working groups we are able to collect business requirements and product development feedback from sell-side and buy-side firms, custodians, outsourcers/administrators, and collateral management vendors that reduce the operational, counterparty, and liquidity risks associated with collateral management.”
