At a time of profound regulatory and macro-economic change and uncertainty, c-suite executives of buy-side firms would be justified in feeling somewhat overwhelmed by the breadth of strategic and operational challenges in front of them. From an operational perspective, the need to upgrade and coordinate collateral management capabilities in line with new regulatory requirements is perhaps one of the most urgent, complex and far-reaching operational challenges.
In Europe, many large asset managers and hedge funds have already begun to implement new processes and establish new relationships to ensure they can pay initial margin and variation margin on centrally cleared interest-rate swaps. Asset managers have also made efforts to ensure they can access and deliver eligible collateral assets as and when margin payments are required by central counterparty clearing houses. The collateral challenge will intensify in 2017, when global rules for buy- and sell-side firms are introduced for the exchange of variation margin for all non-cleared over-the-counter (OTC) derivatives, as identified by the Basel Committee on Banking Supervision (BCBS) and the International Organisation of Securities Commissions (IOSCO).
With as little as six months to go, forward-thinking buy-side firms have a good understanding of their future collateral needs, with the hard work of internal coordination and service provider engagement now underway. While each firm will have its own unique priorities and preferences, the good news is that many proprietary barriers to the movement and monitoring of collateral are being overcome by solutions that leverage open standards and common protocols. As such, the operational re-engineering burden is increasingly one that can be shared across the industry, rather than shouldered entirely by individual firms.
Unlike initial margin, variation margin for bilateral OTC derivatives is not a new concept for most of the buy side. However, the new rules do inject greater velocity and complexity to the collateral arrangements and processes of asset managers and hedge funds. Critically, variation margin must be settled on a same day basis in most major jurisdictions, catapulting the buy side into an all-but-real-time management of collateral assets, having previously settled variation margin the day after the call is agreed or even later depending on the bilateral terms to which the parties have agreeed. And although the new rules don’t significantly constrain choice of assets used for variation margin, some banks are using differentiated pricing to incentivize their clients into specific forms of collateral based on the capital and operational priorities specific to the particular dealer firm.
As such, buy-side firms need to develop or enhance their collateral capabilities specific to collateral visibility, transparency, and mobility which can accelerate the deployment of collateral – it is clear that buy-side collateral management must become more efficient and coordinated to keep pace with future demands. At one level, this may mean a more centralised approach, with a core function liaising with portfolio managers and operations staff responsible for individual funds. It will also entail more process automation and standardisation when interacting with external counterparties and service providers.
When contemplating significant operational changes in light of evolving regulation, it is important to keep the bigger picture in mind. In some respects, the collateral cliff we have been warned about since the financial crisis bears comparison with climate change. Experts still argue over its causes (and even its existence), but globally coordinated rules are being put in place that require us all to make more careful, sustainable use of increasingly scarce resources. Regardless of opinion, the desired response is greater innovation, diversity and collaboration in pursuit of greater efficiency. At a high level, this reduces systemic risk and boosts overall operational robustness by offsetting over-reliance on major players. At a more day-to-day level, firms should benefit from the improved use of finite resources, in part through collaborative efforts, as well as the use of shared infrastructure and network solutions to help resources flow to where they are most needed.
While one might argue that regulation will contribute to collateral scarcity in the interests of reducing counterparty risk, the process changes required for compliance tend to reinforce best practice. For the front office to make optimum use of liquidity, it must have accurate, timely information from the back office on foreseeable collateral calls and settled positions. And for collateral to be paid as cost-effectively as possible, the back office must have similarly high quality intelligence on available and accessible collateral inventory; it must also have certainty that the firm’s extended operational infrastructure – internal and external – is able to deliver collateral without fear of process failure.
Transparency, control and flexibility are not regulatory requirements; they are the building blocks of an efficient, world-class investment operation. As suggested above, firms’ existing client base, investment philosophy and product offerings, among other factors, will determine how their particular internal processes will adjust to upcoming regulatory changes. But when adjusting to these changes, they should also look to seize the opportunities offered by supply-side innovations.
Custodians and central securities depositories are knocking down barriers to the movement of collateral. Utility-based market infrastructures and message networks are using open standards to bring counterparts together more seamlessly, for example to accelerate and automate the exchange of collateral information. Tri-party agents and other service providers are reworking their value propositions business models to help the buy-side access and exchange different collateral types. Technology vendors are developing solutions that provide asset managers and hedge funds with greater visibility of their collateral inventory, but also greater independence in the valuation of collateral and calculation of margin calls. In most cases, these services and capabilities have emerged following a deep and sustained level of engagement between market participants and providers, with steering committees and working groups contributing to the development of solutions that can be brought to market with confidence.
Adjusting to new regulatory requirements may still cause concern for c-suite executives but, at least in the field of collateral management, help is at hand.
