The number of vendors offering collateral management systems has exploded in recent years. Jeff Campbell of Actualize Consulting reviews the questions firms should ask when evaluating collateral management software solutions to select a system capable meeting the new demands of CCP clearing and derivatives regulation
Dodd-Frank has significantly changed how a firm manages their collateral management operation. From calculation to margin call format to reporting; cleared collateral management has standardized and in some cases re-invented the entire process. Reconciliations are now a proactive process, instead of the reactionary ad-hoc process conducted under the bilateral collateral management model. Eligible collateral parameters are severely tightening and firms must be smarter in terms of how collateral is allocated to their counterparties. It’s a “brave new world”, and these new processes and procedures make collateral management not only important, but critical to a firm’s risk mitigation strategy. Combined with the ongoing need to manage a bifurcated model for non-cleared trades, firms need to allocate more funds and resources to ensure they meet the rising importance and demand. Added complexities and ever evolving regulations have made spreadsheets and simple databases too risky to maintain and firms are considering vendor solutions to address those needs.
Selecting the right vendor to manage your collateral operations can be a very complex and time consuming process. There are a variety of solutions available and not every vendor will be best suited for your needs. Historically, firms maintained multiple collateral management shops in silos, based on product type (OTC, repo, futures, etc.). Vendor solutions responded in kind by specializing in one product type, but not all. Response to Dodd-Frank regulations and the cohesion of OTC and listed derivatives has forced vendors to provide comprehensive solutions that provide collateral management across all product types. The “de-specialization” of vendor solutions has increased the number of vendor participants within this space. This should prove over time to offer more robust solutions to firms and force vendors to shorten development times to provide specific functionality and address ongoing regulatory demands.
Historical OTC vendor systems, such as IBM (Algorithmics), Omgeo and Lombard Risk are introducing repo collateral management and/or collateral optimization functionalities as additions to their existing offerings. Trading platforms such as Calypso are utilizing their expertise to bridge the traditional gap between trading and collateral by introducing a collateral solution. Other vendors, such as 4Sight which has strong repo and collateral optimization functionality are broadening their product capabilities to include central counterparty (CCP) clearing and OTC collateral management in one comprehensive product.
When selecting a vendor, it is important to understand your business both in regard to its operational strengths and its weaknesses. How can a vendor solution enhance your business and close operational gaps? How can a vendor grow with your business and the regulatory changes as you move toward a cleared collateral management environment? How can a vendor solution best fit into your infrastructure while maximizing your operational processing? A vendor product should have easy and flexible connectivity with internal and external systems as well as robust reconciliation, reporting, collateral optimization and CCP workflow tools that allow firms to simultaneously support CCP and bilateral processing.
These questions can be best addressed by investing the necessary resources to thoroughly research all vendor options and developing strong RFP and scorecard methods. The RFP should not be overly focused on your specific business needs. While every firm’s process is unique, the industry is moving toward standardization and integration of new processes; not all of which have been wholly defined. A proper RFP must be calibrated to focus significantly on CCP requirements and less so on bilateral collateral management. Attention during the RFP and demo process should be specifically placed on front-to-back CCP margin call processing and overnight automated reconciliation and reporting. Futures Commission Merchants (FCMs) and CCPs are requiring margin calls to be submitted prior to 10 or 11 AM, however, CCP trade values and corresponding fees (PAI, etc.) must be reconciled against internal mark values prior to submission. An RFP should also demand detailed vendor roadmap information and allow firms to anticipate and assure future processes will meet regulatory deadlines.
A proper vendor solution must immediately provide robust functionality on CCP requirements that have already been clearly defined. The first element a vendor system must fully address is the ability to generate margin statements and letters in accordance with CCP requirements. Each CCP has defined its own calculation and the variables (fees, commissions, PAI, etc) that define it. Does the vendor system possess the nuance of each CCP’s requirements and provide the margin statements and call letters in the new formats? FCMs are also using the CCP statement and letter requirements as a baseline for their margin statements and letters for their clients, so ensure the vendor system can support that as well. Most firms are clearing through multiple FCMs and/or CCPs, so the vendor system must be able to independently and simultaneously manage each unique calculation and margin requirements.
The introduction of CCP’s unique workflow processes and collateral agreements have spread the same number of OTC derivative transactions over a multitude of new and pre-existing agreements. Many firms, such as asset managers have seen their number of legal agreements grow significantly due to the number of FCMs and/or CCPs they face on behalf of their clients as well as the ongoing need to segregate each client fund’s collateral. Appropriate vendor solutions should possess dedicated CCP margin call processing and agreement netting capabilities to address potential cross-margining requirements. The increased volume combined with the need to manage two bifurcated collateral management workflows simultaneously and independently have made spreadsheets and basic databases too risky to maintain. Significant enhancements and capital would be required to ensure ongoing regulatory compliance.
Standardization and regulation have placed a great deal of emphasis on collateral management-related reporting. Many collateral management systems historically lack flexible reporting capabilities. With CFTC mandated clearing requirement deadlines looming in June 2013 (Phase 2 entities) and September 2013 (Phase 3 entities), do vendor systems have the ability to standardize and automate reporting to internal and external clients as well as FCMs, custodians and CCPs? Do they remain flexible enough to ensure each entity’s current and future reporting needs? A proper vendor system must flexibly respond to each margin call and reporting mandated requirement while proactively generating and distributing the information as necessary.
CFTC’s swap reporting and external business conduct standards have also significantly impacted a firm’s use of the reconciliation function within their day-to-day operations. Combined with ISDA’s ongoing reconciliation requirements for non-cleared trades, buy-side firms can no longer rely on their brokers to provide swap marks. Firms must proactively reconcile all trades in accordance with these new rules in daily correspondence with their FCM’s and/or CCP’s. Additionally, Dodd-Frank requires swap dealers and MSPs to document and regularly audit written documentation that determines the value of the swap at any time over the life of that transaction. New transparency requirements and regulated reporting deadlines mean all firms must proactively reconcile their derivative portfolios daily.
These new rules and regulations for CCP and bilateral collateral processing inflict a significant increase in operational costs. Compounded with CCP’s demand for high-grade collateral and increased initial and variation collateral requirements on both cleared and non-cleared derivative transactions, the costs of managing a firm’s collateral requirements will continue to increase. As firms experience the sharp decline in eligible collateral, they are actively pushing back on regulators to minimize these impacts. CME’s recent acceptance of corporate bonds as eligible collateral serves as an example of ongoing change. Inclusion of corporate bonds will not wholly stem the tide and firms are leveraging repo and SBL to fund collateral requirements as well as collateral optimization and transformation capabilities to utilize low-grade and less-liquid collateral.
A strong vendor system should possess bilateral, CCP and now repo collateral management workflows. While experts vary in the amount of collateral shortfall generated by CCP requirements, conservative estimates are in the tens of billions. The new excess of ineligible collateral lends itself to utilize repo to fund a firm’s daily collateral requirements. The last major element collateral management will incorporate will be collateral optimization. With firms now in possession of ineligible collateral for CCP, collateral managers sit on assets that no longer have any value to them. Before repo and securities lending will be utilized, firms must look at their legal agreements against their collateral inventory. Could lower-grade collateral still be eligible for a particular agreement(s) and higher-grade collateral be better utilized elsewhere? Could a large portfolio of corporate bonds be pledged to CME while Treasuries could be utilized for ICE? An efficient collateral management practice will merge daily collateral pledging with collateral optimization and transform low-grade collateral through repo and SBL to help offset funding costs.
Ambiguity in the market and the “reinvention” of collateral management as a whole has many firms taking a “wait and see” approach until all rules are finalized. This is evident by CCP and FCM entities openly lobbying for firms to register immediately and test clearing capabilities in advance of Phase 2 and Phase 3 deadlines. General consensus holds that too many firms have not yet complied with requirements and a large percentage could risk missing regulated deadlines.
Despite the aforementioned delay in operational compliance by many firms, some have already responded to these urgent regulations. Some sell-side firms are creatively offsetting the ballooning operational costs by creating new revenue generators. Many dealers already fulfill the role of FCM and margining on behalf of their clients directly with the CCP. This full-service margining includes many features, such as collateral optimization and collateral transformation. The demand for this service is high and dealers are establishing collateral transformation trading desks. This desk’s function is to convert ineligible or low-grade collateral into eligible and higher-grade collateral on behalf of their clients for delivery to the CCP and the cost is added to the service. Again, a viable vendor solution should have collateral optimization and transformation capabilities to give firms the ability to efficiently manage their own collateral and lower costs.
Many firms have begun to perform build vs. buy analysis. Cross-product collateral management and CCP proprietary calculations that are not readily available in the market quickly delineate that building a collateral management solution in-house that addresses all regulatory compliance introduces its own risks. Firms would need to build a flexible and nimble product that can quickly react to ongoing regulated changes and firms would wholly absorb all development and testing costs. Additionally, approximately seventy percent of in-house software costs occur after implementation and building in-house would require firms to significantly invest in an ongoing rigorous lifecycle analysis. This can result in significant capital investment and re-investment into a specialized product that is quickly approaching standardization. Considering the aforementioned increased competition in the vendor solution space and standardization in market requirements; expectations are that license and maintenance fees will decrease over time. These factors have helped firms determine to invest their internal resources elsewhere and rely on a vendor solution.
The industry has changed immensely since the fall of Lehman and the back and forth between regulators and firms will continue to advance that change. Central clearing is encouraging firms to break down operational silos in collateral management, as evidenced by the merging of repo and cleared. Clearinghouses are offering new listed derivatives as alternatives to swaps and bringing OTC and futures closer. Over the next few years, the market will continue to focus on not only collateral optimization but cross-margining. With more OTC product types becoming cleared over time, there will be more and more transactions centrally placed at a CCP. In response, processes will continue to be invented and re-invented and firms should rely on vendors in the collateral management space to provide the best technology and workflow processes to keep them compliant with ongoing regulatory requirements and stabilize an ever-changing industry.
