In 2017 and with BCBS/IOSCO non-cleared margin requirements for OTC derivatives deadlines looming, investment management firms are increasingly focused on improving their collateral management processes to meet new and forthcoming regulatory and market requirements. Eleonore de Vial, Senior Product Manager at Misys, discusses techniques buy-side firms are adopting to maximize control and make the most of their collateral.
For many buy-side firms, improving collateral management processes has been top of mind for the last two years. Regulation is the main driver, with BCBS/IOSCO margin requirements for non-cleared OTC derivatives coming into force in the next year. However, as this requirement is being applied gradually from the largest to the smallest firms, it is still quite a way off for many firms.
The other significant driver is that their sell-side counterparties are already subject to new regulation, and as such are requiring daily variation margin exchange, much more frequent initial margin exchange, and they now need to post initial margin as well. Investment managers were not previously used to receiving initial margin as this was typically handles by the fund administrator. They do not have the expertise in terms of the legal agreements required for what needs to be changed, or how to receive collateral. The buy side is a bit behind where they need to be in this respect as there is no regulatory push right now, but they are being impacted because of increased pressure from the sell side.
As the next group of sell-side firms are impacted in 2017, the pressure from counterparties to post and receive initial margin will increase. Therefore, it is essential that investment managers start projects now to prepare themselves to handle these requirements when they come into play.
Investment Management Collateral Techniques
The buy side uses fairly basic collateral optimization techniques. While some firms may use securities for collateral—or instruct their prime brokers to do so for them—most of our clients still use cash to cover their margin requirements. They also tend to outsource collateral management to a fund services provider or their prime broker and are more focused on trading activities and electronic connectivity to the counterparty rather than optimisation. In short, optimisation is considered as a nice-to-have capability, by our client base at least, but it is there and it can be a key differentiator for firms that use it extensively.
Pension fund and insurance firms have many high-quality assets in their portfolios, namely government bonds, which are ideal for posting as collateral. These firms are beginning to realize they can lend these high-quality assets to people who are in need of collateral-eligible securities. As a result, they are starting to look at the repo market, and either lend directly or outsource the management of the lending book to a third party.
Most firms currently use an intermediary like their custodian or prime broker, who would leverage the book of eligible collateral that they don’t use, but some are starting to consider doing it themselves, to remove this intermediary step.
Control Rather Than Optimisation
Regulation is pushing buy-side firms towards greater collateral volumes, daily variation margin, and monthly initial margin. This means a lot of exchange with a lot of counterparties. To deal with this volume, they can either hire more people to deal with all the extra phone and email communication to agree on amounts and process exchanges, or they can automate margin call-related communications, so everything is matched and agreed on an external platform. This enables them to process margin calls in a few clicks across all their counterparties, so they are just dealing with the exceptions. This way, about 90 percent of margin calls would be handled via straight-through processing (STP) with no manual intervention. As volumes get higher and higher, so does the need for automation.
Buy-Side vs Sell-Side Approach
Exchange of margin is like a ping-pong game, requiring symmetry between the buy side and the sell side. The buy side can either passively accept everything that comes along, or they can use the same tools that the sell side is using, to be able to challenge what is being requested from them and choose how they want to cover a margin call.
As Misys provides financial software to 48 of the top 50 banks globally and 12 of the top 20 asset managers, we were uniquely placed to build an enterprise collateral management solution to meet the needs of both the buy side and sell side. The collateral management functionality we deliver is the same for investment managers and their brokers. We are therefore able to provide our buy-side customers with the same tools their sell-side counterparties are using, with the same development capacity, optimization capabilities, connectivity with the CCP and margin capabilities. This ensures the collateral process is consistent and moreover, streamlined for greater operational efficiency.
Outsourcing
Some investment managers are looking to outsource their collateral management operations or some of the functions to a service provider, such as an asset-servicing firm, or even to a market utility service. Most are still in the evaluation stage. It is a compromise between cost and control—if firms outsource, it may be cheaper, but they have less control. Importantly, reconciliations can be more difficult and having an accurate, real-time view of the portfolio with visibility over what is being used as collateral can be more challenging, if not impossible, when firms do outsource.
At the same time, it is a commoditized function. A lot of asset servicers offer collateral management and reporting services. The pricing model is usually per agreement and per volume of margin call. As volumes grow, the buy side should consider whether outsourcing is the best solution, or whether they should manage it in house with an automated system that doesn’t require too many people to deal with daily margin calls.
Those firms that outsource their collateral management will usually invest in a stronger reconciliations system, so they can import the data being sent by the asset servicer. Firms that currently outsource to their prime broker might want to move to a central asset servicer, who will manage all the collateral across all the agreement types.
For investment managers – it starts with an enterprise view of inventory
The first thing buy-side firms need to do is have an enterprise view of their securities inventory. They can no longer rely on disparate systems with different securities being held at various custodians, and trying to aggregate that in another system. They need to have one view where they can see all their securities, with real settlement dates, and be able to import the custodian statements to have an accurate view of where exactly their securities are.
From there, firms can build a collateral management solution with proper optimisation and connectivity capabilities to manage the margin call workflow in the most effective way possible, so they can handle the higher volumes without having to increase headcount. Our buy-side customers at Misys already benefit from this approach via the FusionInvest solution, which uses an integrated approach to portfolio management, risk, compliance and investment operations including collateral management. It is only with this single system approach across all asset classes and functions that buy-side firms can have the transparency and consistency throughout the investment process to make informed decisions that can make a difference to the bottom line.
Closing remarks
To have the most control over their assets, buy-side firms need to manage collateral requirements internally to know exactly what they are lending, what the settlement statutes are and crucially, was the security really delivered or not? If they can’t do this due to a lack of internal resources for example, they should at least have the infrastructure and the IT environment to be able to import and aggregate all the information coming from the asset servicer, the custodian or prime broker in a single view to understand where their securities actually are and ensure they are being used optimally.
