Regulation change has placed a premium on the collateral optimization process. While it becomes a critical component of efficient and effective collateral management, there is a lot of white noise around the topic for buy-side firms. Jeff Campbell of Actualize Consulting explores how far a firm needs to go to achieve optimal use of collateral.
As it’s been well documented over the past year, Dodd-Frank and EMIR regulations are projected to generate a collateral crunch up to 2 trillion USD. This large spike in required collateral is largely due to increased initial margin requirements by CCPs and firms such as pension funds and other institutional investors experiencing collateral requirements for the first time. The joint report by the Basel Committee on Banking Supervision and International Organization of Securities Commissions (IOSCO) that was released on September 2, 2013 modified its earlier proposals regarding FX margining and rehypothication. Eliminating initial margin requirements on FX swaps and forwards as well as the introduction of a “one-time” rehypothication could have a positive impact on collateral funding. However, it’s too early to tell whether that will come to fruition and if it does what that impact will be.
Firms have finite resources and budgets to address the litany of regulatory requirements demanding immediate attention and it’s difficult to prioritize and invest in a regulatory initiative without making strong counter-arguments to determine another requirement is just as important. Collateral optimization, however, while not a regulatory requirement per se, it’s a process that should be considered with the utmost importance as it’s relatively easy to implement and cost savings can be immediately achieved by utilizing unencumbered assets. As most firms don’t have a “global” view of all assets throughout an organization, collateral pledging would otherwise be sought through repo or securities lending arrangements to procure high-grade collateral while perfectly acceptable assets would continue to remain dormant.
Presently, firms are embedded in a historic non-cleared collateral management environment; predicated upon large coffers of available collateral that is arbitrarily pledged on a “first come first serve” basis. Stricter eligible collateral parameters, steeper haircuts and increased margin requirements are major factors forcing firms to re-evaluate how collateral is pledged to satisfy clearinghouses and regulators. Each firm must take steps to corral all assets across the firm and manage them from one central location. CCP same-day settlement window requires collateral to be the right type, in the right place and at the right time. This is a daunting task as not all needs can be anticipated in advance, and virtually impossible if a firm’s assets are not aggregated properly.
Collateral Optimization will provide much-needed relief. In its most basic form, optimization aggregates all the firm’s assets, and then intelligently pledges those assets to counterparties based on any number of variables, such as a firm’s associated “cost” they assign to that asset. While many products and services in the market incorporate advanced algorithms and other “bells and whistles”, those benefits are not necessary for most firms. Incorporating a simple process that focuses on Aggregation of a firm’s assets, Ranking and prioritizing those assets, and calculating an asset’s Cost, or as I describe it to clients “ARC” (Aggregation, Ranking and Cost), will procure cost savings and operational success.
To determine an asset’s cost, firms should review any costs associated with servicing the asset while it resides in the firm’s accounts. Cost analysis should also include other variables, including cost of carry, opportunity costs, corporate actions and transfer pricing rates/models, which would represent the fee(s) one group or desk charges the other for the use of their collateral.
Lastly, when analyzing cost elements, firms should also consider what is “optimal” from a post-trade versus pre-trade perspective. As collateral management has risen in profile, traders are now looking at collateral as an element to consider before putting a trade on the books. What collateral is “cheapest to deliver” for a particular trade? Which CCP will charge the least initial margin and provide the most advantageous haircuts for this new trade? Collateral managers will need to monitor each trade as part of a collective view and what collateral might be optimal in a post-trade analysis is likely not the same as determined by the trading desk in the pre-trade analysis. Providing collateral optimization to the front office will ensure lower-grade yet eligible collateral is used for the complete trade lifecycle and minimize extraneous collateral substitutions.
Firms should immediately focus on aggregating all available assets across the firm into one centralized location and create a “model” to determine a true cost of collateral. Understanding what collateral a firm has available as well as its associated costs, firms can appropriately prioritize and rank how collateral is intelligently utilized for daily pledging purposes and provide significant cost savings and more efficient collateral management. Investing in systems and processes that introduce advanced algorithms and other expensive features might be appealing and appear to alleviate all optimization headaches. However, going beyond these basics could introduce diminishing returns and add operational and technical complexities that are simply unnecessary when a simple approach could provide all the optimization your firm requires. Sometimes less is more.
