UMR: A sheep in wolf鈥檚 clothing?
29 October 2019
The UMRs are often painted as just another burden to be managed, but will they also drive more firms into the securities finance markets to access assets for initial margin? Industry experts debate the opportunities
Image: Shutterstock
The panel
Ted Allen, business development director, securities finance and collateral, FIS
Todd Crowther, business development and head of client innovation, Pirum
Richard Gomm, head of EMEA banking industry, VERMEG
Shaun Murray, managing partner, Margin Reform
Mike Reece, head of EMEA sales, banks, platform sales, 网爆吃瓜 Services, J.P. Morgan
Discuss the key trends within the collateral space right now.
Ted Allen: Clearly, preparations for waves five and six of the Uncleared Margin Rules (UMR) for bilateral over-the-counter (OTC) derivatives are front of mind for many firms. The impact on collateral usage will be significant for many as it is a catalyst to centralise collateral management and securities finance in the front office. UMR will increase the demand for high-quality liquid assets (HQLA) to meet initial margin (IM) calls, which will have a consequential knock-on impact for securities lending and treasury management. It will also create opportunities for some sitting on pools of HQLA that will be in higher demand. Centralised optimisation of inventory allocations will result and firms will also look to optimise trading decisions to minimise the margin impacts.
Mike Reece: The convergence of several themes and requirements makes this a very interesting time for collateral managers. In recent years we鈥檝e been discussing requirements for more data standardisation and interoperability across markets; the need for firms to view collateral holistically and mobilise effectively across instruments, venues and regions; and finally, the evolution of sell-side optimisation from an outsourced, cheapest-to-deliver algorithm to more flexible, interactive user tools and better communication between triparty agents and borrowers. This change in triparty providers鈥� optimisation capability is essential to enable each borrower鈥檚 ability to optimise in-house and allocate versus their binding constraints 鈥� noting that this all needs to operate effectively alongside traditional triparty allocation solutions.
Buy-side optimisation is also emerging as a core requirement and potential opportunity, primarily in response to the final stages of UMR. Buy-side firms now face decisions on how to support complex margin management requirements, alongside other liquidity constraints and opportunities.
Beyond regulatory considerations, a renewed focus on environmental, social and corporate governance (ESG) investment parameters will add further complexity into the mix of general collateral challenges for both buy and sell side. The buy side will need to balance the requirement to widen collateral providers to improve attractiveness in securities lending versus a potentially narrower ESG policy and collateral acceptance, while the sell side may be restricted in posting collateral in reverse. At a minimum, this will require careful eligibility management and monitoring.
Finally, we can鈥檛 ignore the potential for new technology to enable more efficiency within the collateral system, plus the role of new entrants focusing on data solutions and tokenisation, for example. We are starting to see some much more tangible initiatives around data solutions and tokenisation that could have huge potential for future application. Within this fast-changing environment, collateral managers, and particularly triparty agents, have a central role to play in enabling effective optimisation and mobilisation within an increasingly complex and interconnected ecosystem.
Richard Gomm: Automation, connectivity and both pre- and post-trade optimisation are without a doubt the three key trends in the collateral space right now. The need for greater automation is prevalent due to the increase in margin call volumes and potential disputes created by UMR. Via automation of the margin workflow via straight-through processing rules, the collateral management process becomes one of exception management. Automation enables margin managers to concentrate on the issues at hand rather than time-consuming manual processes and thus eases the burden on capacity and mitigates operational risk.
Direct connectivity to central counterparties (CCPs), triparty agents and third-party custodians are, as we know, a key pain-point within the industry due to the complexity of message formats and lack of standardised interfaces. Firms should seek technology or platform providers that have full triparty and CCP connectivity. There has been a significant increase in client appetite pertaining to the validation of valuations and eligibility checking of third-party access and CCP allocations. Since the Lehman Brother鈥檚 collapse in 2008, customer relationship management teams now look to de-risk all processes and, as a result, gone is the antiquated view that firms just accept that requirements have been covered in full by eligible assets that adhere to both concentration limit and haircut parameters.
Pre- and post-trade optimisation are now also fundamental to market liquidity. Technology providers should be able to offer both. As the cost of collateral rises due to UMR, more and more firms are looking to reduce the cost per trade. This can be done via the use of pre-trade analytics. Firms should be able to reduce their cost of cleared trades via value-at-risk and Monte Carlo simulated calculations ensuring that all cleared trades are given up to the CCP. Post-trade optimisation needs to be across products to break down the institutional siloed approach. It should also be flexible in terms of algorithms and rules to be applied. Firms need to be able to build their own rules as optimisation doesn鈥檛 always mean the cheapest to deliver and means many different things to different firms 鈥� five out-of-the-box rules may not satisfy this requirement. Firms also need the ability to periodically reassess collateral posting to ensure that all held and pledged positions are always the most optimal.
Shaun Murray: At Margin Reform, collateral breaks down into six key areas: strategy, technology, optimisation, risk and regulation, training and communications and legal and compliance. Each area means different things to different firms dependant on their starting point and where they want to end. The largest firms with the biggest budgets and the deepest expertise will have a different focus to firms who are now having to understand the regulatory dynamics, technology options and costs associated with either investing for the future or doing the best with what they have to meet and attain compliance.
No journey is the same and while evolution continues in the collateral space at a pace, all of the trends are functionally caught in the six key areas. Being a trendsetter is one thing, getting the basics correct, building the foundations in the right way and ensuring you future proof yourself are more important.
Todd Crowther: Firms are seeking:
Visibility: Consolidated view of margin requirements and collateralised transactions across various underlying products (securities financing transactions and UMR) and multiple collateral venues where real-time, network data is utilised to monitor and process the coverage of exposures in an accurate, efficient and timely manner.
Connectivity: Establishing better connectivity across the collateral ecosystem and more easily enable networking between market participants, triparty and third-party custodians, CCPs, outsource collateral agents, trade repositories, etc.
Interoperability: Leverage network to streamline and automate the full margin lifecycle by turning complex, manually intensive tasks into efficient, scalable and controlled workflow processes that are shared between counterparts.
Cost-effectiveness: Outsourced solutions are more cost-effective than in-house, hosted systems. A service fee replaces initial development costs; a single instance means that upgrades are more easily deployed; professional services are no longer required to maintain, support, user test nor update solutions as this becomes the responsibility of the service provider. Outsourced services also reduce development and integration timeframes as well as enable better controls from continually evolving security controls and infrastructure.
What is collateral trading and what is the main purpose of these trades?
Crowther: Collateral trading is undertaken to fulfil a collateralised exposure in the most efficient manner. These trades are undertaken to either raise, distribute or transform collateral to fulfil or enable the fulfilment of a margin requirement.
Allen: We are expecting UMR phase five and six and the extension of the clearing mandate for category three and four firms to increase the demand for HQLA to meet IM calls. This will drive collateral trading as those entities that are not naturally holders of these assets enter the securities lending market to access them.
Murray: The answer to this depends on the type of organisation you are speaking to and the role of the person. For some this is about P&L generation, servicing the client base and managing risk. On the treasury side, I may be looking for a collateral upgrade or downgrade to manage my balance sheet, or I could be a buy-side entity looking to optimise my collateral posting. In all events, there are factors everyone is considering such as the regulatory overheads, HQLA, balance sheet pressures and capital efficiency. The evolution of collateral trading to longer-dated, cross-asset, cross-geography client servicing and optimisation, plus the use of different legal structures such as 鈥榩ledge鈥�, will keep the market on its toes for the foreseeable future.
How will UMR affect the collateral marketplace?
Murray: UMR has already had a major affect on the industry. The first 4 phases are exchanging two-way regulatory IM, $170 billion across phase ones according to ISDA鈥檚 2018 year-end survey. Everyone has developed or implemented an IM model, mainly ISDA SIMM, and all have new processes, procedures, governance and regulatory oversight to contend with. Phases five and six are estimated to be much larger in terms of the number of impacted counterparty groups and they have to now decipher what they need to comply with, how they have to comply and whether they are able to utilise the monitoring aspects that the Basel Committee on Banking Supervision and International Organization of 网爆吃瓜 Commissions (BCBS-IOSCO) statement alluded to by acting diligently.
The business as usual day-to-day processing is critical to get right. It varies from the management of your liquidity and funding requirements, the servicing of the long box for regulatory IM purposes, the external relationships with the custodial agents through triparty or third-party and dispute management, which will span operations and risk teams. In the longer term, we should expect to see all organisations focusing on the collateral dynamic, putting more emphasis on pre-trade analytics, moving to step-change technological improvements and enhancing internal connectivity across front office teams and their support areas in risk, legal and operations to increase efficiency and garner a better understanding of costs and the subsequent allocation of those costs to the correct place.
Gomm: Since the 2008 financial crisis, regulators have made huge strides towards stabilising the global financial system via regulatory reform. The US Dodd-Frank Act, Basel III, the European Market Infrastructure Regulation (EMIR) and other global equivalents have provided a tidal wave of regulatory change which, in the current economic climate coupled with stressed market conditions, has exasperate institutions鈥� antiquated IT infrastructures, the lack of regulatory compliance, increased margin and dispute volumes, added to the adverse operational capacity, selection of IM calculation methodology and the subsequent squeeze on high grade collateral. However, institutions that were due to be impacted by UMR phase five, are now breathing a huge sigh of relief after the Basel Committee on Banking Supervision (BCBS) and IOSCO announced a one-year extension. Firms with an average aggregate notional amount of greater than 鈧�8 billion, but lower than the interim 鈧�50 billion threshold, will now be required to exchange IM in September 2021; 12-months later than the original mandated date. Many phase VI firms, particularly those domiciled in the US, will no longer be required to physically exchange daily IM with a large subsection being required to provide the underlying calculation of IM requirements only. However, streamlining IM requirements is much greater than purely choosing between schedule-based (GRID) IM and SIMM calculation methodology. Firms need to take a strategic, rather than tactical approach, thereby maximising automation, connectivity to triparty agents and CCPs, optimisation and efficient inventory management. This will ensure regulatory compliance, collateral mobilisation giving rise to competitive edge.
Allen: UMR will add complexity to firms in the over-the-counter derivatives market as they and their counterparties work to become compliant. This impacts legal, risk, treasury, front office and operations given the scope of the requirements. Those firms that have centralised collateral management and securities finance onto a single platform, such as Apex which supports the regulations, will be in an advantageous position. UMR will drive many firms into the securities lending market to access and use the assets needed for IM. Firms will be using systems that provide a central platform for securities finance and collateral, more and more. The decision to centralise these disciplines is both an organisational and an infrastructure question. We are all concerned about how regulations stop people getting on and doing their business. However, this regulation could paradoxically have a positive effect on securities finance.
Reece: I think the immediate impact, especially from the final phases, will be the significant time, effort and resources required across the industry to implement the rules efficiently. Given the scope and scale of participants in phases five and six, all industry participants will need to work together effectively. One of the longer-term benefits is likely to be increased interoperability between collateral providers, especially triparty agents, venues and vendors. As noted earlier, the final rule phases will also prompt a decision for buy-side firms. They can choose to implement a tactical solution to meet the requirements, or they can opt for future-proofing with a robust, end-to-end collateral optimisation solution across margin, liquidity and portfolio performance. Given ongoing pressures on spreads and shifting demand for liquidity, as well as the new margin obligations, choosing to work with firms who specialise in collateral, agency financing and lending solutions, with the expertise, scale and access they bring, is an increasingly attractive option. With the 2020 deadline fast approaching, buy-side firms should be deciding on their partners now.
Why should the firms aim for a centralised collateral management infrastructure?
Reece: Whatever the collateral obligation or opportunity firms are aiming to execute against, it鈥檚 important to have the broadest possible view and access across their portfolio. From a sell-side perspective, allocating collateral efficiently is now so much more complex, given the various capital, funding and liquidity constraints they are managing to - it鈥檚 not just a case of prioritising lower-quality collateral.
Considerations related to counterparty, house-versus-client activity and duration are all critical in allocating collateral efficiently versus a firm鈥檚 binding constraints. Being able to view a broad portfolio is key, but firms also need to be able to mobilise across business lines and time zones to access the collateral and then be able to allocate and lock into trades effectively. It鈥檚 impossible to manage this process efficiently in traditional product and business silos.
Allen: Centralising collateral management, securities lending and treasury management can greatly improve efficiency. A given pool of assets can be used in the repo market to gain cash for variation margin, it can be used to raise revenue in the securities lending market or it can be transformed to access the securities needed. Only if these decisions around allocations are centralised, can firms avoid the spreads of going externally to access what is needed and to ensure the inventory is allocated optimally across all requirements.
Gomm: Many organisations still operate separate collateral pools to manage margin. Often this means the structure does not enable margin netting and compression to realise collateral and cost efficiencies for revenue-generation opportunities and can result in sub-optimal use of collateral inventory. If you include bilateral margin calls and settlement liquidity, then there is potential to utilise your triparty collateral arrangements to service a wider pool of business needs. The ability to break-down product silos and provide a holistic, cross-product view of risk to optimise firm-wide collateral inventories gives rise to competitive advantages which are not only proving to be critical to the success of any institution but for the financial industry as a whole. Therefore, the belief is that a centralised collateral management infrastructure is critical and should be at the forefront of any solution provided by fintech companies.
Murray: There is a multitude of reasons all firms should be looking to centralise when they consider collateral; the two most important are connectivity and simplicity. The embedded and increased risk and costs of the collateral regulatory environment needs management. Being joined up internally and externally, understanding the impact that a particular role has upstream and downstream leads to a more open and transparent approach to the collateral chain, which automatically brings a more efficient way of operating. In turn, being efficient leads to reduced costs. From a connectivity perspective, you should be working on a real-time basis, which is far more conducive to risk and liquidity management and ultimately can improve the top-line metrics through better balance sheet and risk-weighted assets management.
Crowther: Consolidated, enterprise-wide solutions can offer better cost-effectiveness, improved business returns and a more controlled, scalable solution in terms of a firm鈥檚 target operating model.
What are the key challenges that organisations would face with this?
Crowther: The key to this is a firm鈥檚 ability to have the visibility and connectivity needed to view and action coverage, agree or dispute exposures and effect collateral mobilisation to cover margin calls and this relies on the ability to collaborate not only a firm鈥檚 counterparts but also its different infrastructure providers across different technologies.
The ecosystem is becoming much more complex 鈥� more products, more counterparties, more venues, more regulations 鈥� but standardised, automated technology should make the process of managing that growing spider web of complexity much easier.
The key points to enterprise-wide solutions are connectivity and real-time visibility 鈥� whether that be connecting with counterparties, infrastructure providers or utilities - firms should make sure they connect into that network to efficiently mobilise assets and agree on collateral. No firm can do that by themselves, they need to be outward-looking.
Allen: Building a business case for a budget for centralisation is a challenge. There is also an opportunity in regulatory deadlines for UMR and the 网爆吃瓜 Financing Transactions Regulation (SFTR), which do require firms to look at their collateral infrastructure. I would urge firms to use this opportunity not to just do the minimum for compliance but to look at their collateral and securities finance infrastructure and invest to realise the benefits of centralising and optimising across front middle and back office.
Murray: There are multiple challenges to a centralised infrastructure which starts with the investment of those scarce resources, time and money, both of which need to be supported by their friend, expertise. The first and most crucial stage is to define the problem statement: what problem are you solving? Who is going to be responsible for the centralised infrastructure, is there a 鈥榗ollateral owner鈥� with the autonomy to bring success to the organisation? Are they backed by multiple stakeholders supporting them across product, functional and geographical footprints? Which (whose) problems do you solve first? What do you want the end-point to look like? Will the scare resources stretch far enough? There are several ways to break this down into manageable chunks and that should be a key consideration for all, as we鈥榲e already recognised, collateral is rapidly evolving, some parts of the infrastructure are more important than others. Ultimately, organisations have the same challenges but they have a different priority weighting which needs to be understood at the outset.
Gomm: For years many firms have considered the move away from siloed processes. However, often such implementations can be costly, time-consuming and turn into multi-year projects. Many institutions still have antiquated infrastructures and internal data issues. Data quality and availability are a real issue throughout the industry and often represent the greatest risk to an organisation鈥檚 ability to operate a centralised collateral management infrastructure. Fortunately, there are fintech companies in the market place that are offering truly cross-product solutions. These solutions are geared towards both sell and buy-side organisations, providing hosted or a cloud-based infrastructure that removes the technical burdens and enables real cost and efficiency benefits.
Reece: For most firms, the main challenge is changing working practices and processes that developed over multiple years and have previously worked effectively. Aside from considerations around the front office, in terms of competing strategies, profit and loss (P&L) and balancing firm and individual desk priorities, the key challenge is often managing operations and heritage technology stacks.
Technology can pose a particular problem: for example, when we look at fixed income and equities business lines, the technology and associated downstream processing has often grown up in completely separate business lines. Realigning back, middle and front offices priorities within an already challenging market environment is a big decision, although the long term benefits are clear. To be effective, the role and responsibility for centralised collateral management infrastructure generally needs to be mandated from the top of the house. The full benefits from optimisation and mobilisation solutions through triparty agents and the broader ecosystem are magnified as firms move to a centralised collateral management infrastructure, through both scale and efficiency.
What other regulations do firms have to contend with in this space?
Reece: SFTR and the Central 网爆吃瓜 Depositories Regulation (CSDR) are both significant requirements that firms need to prepare for ahead of 2020. We shouldn鈥檛 underestimate the amount of work required or the impact of not being properly prepared, but there are clearly longer-term benefits to consider. I referenced the industry鈥檚 growing focus on consistent data standards, harmonised markets and interoperability, but the reality is it鈥檚 often very difficult to drive this purely as an industry initiative.
Regulation is often the catalyst for firms to prioritise funding and resources to an initiative, and so requirements from SFTR and CSDR will almost certainly deliver significant advances in data consistency, standardised reporting and harmonised markets. The timing of the International 网爆吃瓜 Lending Association鈥檚 鈥楢genda for Change鈥� whitepaper and suggested 鈥榗ommon domain model鈥� are also well placed to help maximise benefits in this area.
Crowther: The European 网爆吃瓜 and Markets Authority/EMIR are creating greater complexity by requiring collateral segregation and enforcing stricter eligibility requirements, BCBS is mandating improved liquidity profiles, greater capital buffers, more cleared products and higher-margin thresholds, SFTR and CSDR will affect collateral liquidity and widen market spreads whilst various government programmes such as quantitative easing and UCITS IV continues to impact availability of HQLA.
Murray: In Europe, you have SFTR, which has been front-and-centre of industry and media discussions for well over 12-months, unfortunately, that doesn鈥檛 seem to have materialised in an advanced state of readiness across the industry when you consider planning and execution. CSDR regulation hasn鈥檛 had the same fanfare that we have seen for SFTR or UMR, but firms who underestimate its impact, in particular, the settlement discipline regime which is due in 2020 could be in for a shock.
Additionally, in the EU we await clarification on the EMIR Refit and the requirements for IM model approval which are expected to be proportionate to the size of the firm, the larger you are the more onerous it will get.
For the Interbank Offered Rate purposes BCBS-IOSCO recently stated that if you鈥檙e amending legacy derivative contracts solely to address interest rate benchmark reforms then you are not required to apply margin requirements for UMR. Assuming this position receives regulatory support, it means firms will have to have a systematic and automated way of ensuring such trades do not pollute their IM calculations. Documentation wise, credit support annexe or central securities depositories referencing the London Interbank Offered Rate or equivalent rates will need to be identified and have some form of an amendment or ISDA protocol executed.
Does liquidity scarcity exist or do you just have to know where to look?
Reece: While there are always conversations about liquidity, market feedback suggests that you just need to know where to look and/or have the capability to transform assets as required.
Gomm: It certainly exists as UMR represents a regulatory landscape, the likes of which have never been seen before, which has the collateral pool shuddering at the concept of an unprecedented demand for collateral comprised of high-grade assets and an increase in haircut provisions. While it is noted that increased collateral requirement in the market means greater safeguards against default, conversely, the ever-increasing demand for high-grade collateral also has an inherent destabilising market factor. Buy-side institutions have limited access to large inventories of high-grade collateral which gives rise to the phenomenon known as a 鈥渃ollateral scarcity鈥�. However, historically back off domiciled processes are now becoming key drivers of P&L. Sell-side firms can capitalise on the need for transformation and Secured financing services.
Secured finance transactions and post-trade optimisation techniques are fundamental to the provision of an untapped global inventory of high-grade collateral to smaller institutions and buy-side clients, while simultaneously providing sell-side institutions with further profitable business and revenue streams. Therefore, access to high-quality collateral positions via secured finance transactions and post-trade optimisation strategies coupled with competitive edge gained from technological efficiencies, are vital to market liquidity and thus the elimination or easing of the collateral scarcity phenomenon.
Ted Allen, business development director, securities finance and collateral, FIS
Todd Crowther, business development and head of client innovation, Pirum
Richard Gomm, head of EMEA banking industry, VERMEG
Shaun Murray, managing partner, Margin Reform
Mike Reece, head of EMEA sales, banks, platform sales, 网爆吃瓜 Services, J.P. Morgan
Discuss the key trends within the collateral space right now.
Ted Allen: Clearly, preparations for waves five and six of the Uncleared Margin Rules (UMR) for bilateral over-the-counter (OTC) derivatives are front of mind for many firms. The impact on collateral usage will be significant for many as it is a catalyst to centralise collateral management and securities finance in the front office. UMR will increase the demand for high-quality liquid assets (HQLA) to meet initial margin (IM) calls, which will have a consequential knock-on impact for securities lending and treasury management. It will also create opportunities for some sitting on pools of HQLA that will be in higher demand. Centralised optimisation of inventory allocations will result and firms will also look to optimise trading decisions to minimise the margin impacts.
Mike Reece: The convergence of several themes and requirements makes this a very interesting time for collateral managers. In recent years we鈥檝e been discussing requirements for more data standardisation and interoperability across markets; the need for firms to view collateral holistically and mobilise effectively across instruments, venues and regions; and finally, the evolution of sell-side optimisation from an outsourced, cheapest-to-deliver algorithm to more flexible, interactive user tools and better communication between triparty agents and borrowers. This change in triparty providers鈥� optimisation capability is essential to enable each borrower鈥檚 ability to optimise in-house and allocate versus their binding constraints 鈥� noting that this all needs to operate effectively alongside traditional triparty allocation solutions.
Buy-side optimisation is also emerging as a core requirement and potential opportunity, primarily in response to the final stages of UMR. Buy-side firms now face decisions on how to support complex margin management requirements, alongside other liquidity constraints and opportunities.
Beyond regulatory considerations, a renewed focus on environmental, social and corporate governance (ESG) investment parameters will add further complexity into the mix of general collateral challenges for both buy and sell side. The buy side will need to balance the requirement to widen collateral providers to improve attractiveness in securities lending versus a potentially narrower ESG policy and collateral acceptance, while the sell side may be restricted in posting collateral in reverse. At a minimum, this will require careful eligibility management and monitoring.
Finally, we can鈥檛 ignore the potential for new technology to enable more efficiency within the collateral system, plus the role of new entrants focusing on data solutions and tokenisation, for example. We are starting to see some much more tangible initiatives around data solutions and tokenisation that could have huge potential for future application. Within this fast-changing environment, collateral managers, and particularly triparty agents, have a central role to play in enabling effective optimisation and mobilisation within an increasingly complex and interconnected ecosystem.
Richard Gomm: Automation, connectivity and both pre- and post-trade optimisation are without a doubt the three key trends in the collateral space right now. The need for greater automation is prevalent due to the increase in margin call volumes and potential disputes created by UMR. Via automation of the margin workflow via straight-through processing rules, the collateral management process becomes one of exception management. Automation enables margin managers to concentrate on the issues at hand rather than time-consuming manual processes and thus eases the burden on capacity and mitigates operational risk.
Direct connectivity to central counterparties (CCPs), triparty agents and third-party custodians are, as we know, a key pain-point within the industry due to the complexity of message formats and lack of standardised interfaces. Firms should seek technology or platform providers that have full triparty and CCP connectivity. There has been a significant increase in client appetite pertaining to the validation of valuations and eligibility checking of third-party access and CCP allocations. Since the Lehman Brother鈥檚 collapse in 2008, customer relationship management teams now look to de-risk all processes and, as a result, gone is the antiquated view that firms just accept that requirements have been covered in full by eligible assets that adhere to both concentration limit and haircut parameters.
Pre- and post-trade optimisation are now also fundamental to market liquidity. Technology providers should be able to offer both. As the cost of collateral rises due to UMR, more and more firms are looking to reduce the cost per trade. This can be done via the use of pre-trade analytics. Firms should be able to reduce their cost of cleared trades via value-at-risk and Monte Carlo simulated calculations ensuring that all cleared trades are given up to the CCP. Post-trade optimisation needs to be across products to break down the institutional siloed approach. It should also be flexible in terms of algorithms and rules to be applied. Firms need to be able to build their own rules as optimisation doesn鈥檛 always mean the cheapest to deliver and means many different things to different firms 鈥� five out-of-the-box rules may not satisfy this requirement. Firms also need the ability to periodically reassess collateral posting to ensure that all held and pledged positions are always the most optimal.
Shaun Murray: At Margin Reform, collateral breaks down into six key areas: strategy, technology, optimisation, risk and regulation, training and communications and legal and compliance. Each area means different things to different firms dependant on their starting point and where they want to end. The largest firms with the biggest budgets and the deepest expertise will have a different focus to firms who are now having to understand the regulatory dynamics, technology options and costs associated with either investing for the future or doing the best with what they have to meet and attain compliance.
No journey is the same and while evolution continues in the collateral space at a pace, all of the trends are functionally caught in the six key areas. Being a trendsetter is one thing, getting the basics correct, building the foundations in the right way and ensuring you future proof yourself are more important.
Todd Crowther: Firms are seeking:
Visibility: Consolidated view of margin requirements and collateralised transactions across various underlying products (securities financing transactions and UMR) and multiple collateral venues where real-time, network data is utilised to monitor and process the coverage of exposures in an accurate, efficient and timely manner.
Connectivity: Establishing better connectivity across the collateral ecosystem and more easily enable networking between market participants, triparty and third-party custodians, CCPs, outsource collateral agents, trade repositories, etc.
Interoperability: Leverage network to streamline and automate the full margin lifecycle by turning complex, manually intensive tasks into efficient, scalable and controlled workflow processes that are shared between counterparts.
Cost-effectiveness: Outsourced solutions are more cost-effective than in-house, hosted systems. A service fee replaces initial development costs; a single instance means that upgrades are more easily deployed; professional services are no longer required to maintain, support, user test nor update solutions as this becomes the responsibility of the service provider. Outsourced services also reduce development and integration timeframes as well as enable better controls from continually evolving security controls and infrastructure.
What is collateral trading and what is the main purpose of these trades?
Crowther: Collateral trading is undertaken to fulfil a collateralised exposure in the most efficient manner. These trades are undertaken to either raise, distribute or transform collateral to fulfil or enable the fulfilment of a margin requirement.
Allen: We are expecting UMR phase five and six and the extension of the clearing mandate for category three and four firms to increase the demand for HQLA to meet IM calls. This will drive collateral trading as those entities that are not naturally holders of these assets enter the securities lending market to access them.
Murray: The answer to this depends on the type of organisation you are speaking to and the role of the person. For some this is about P&L generation, servicing the client base and managing risk. On the treasury side, I may be looking for a collateral upgrade or downgrade to manage my balance sheet, or I could be a buy-side entity looking to optimise my collateral posting. In all events, there are factors everyone is considering such as the regulatory overheads, HQLA, balance sheet pressures and capital efficiency. The evolution of collateral trading to longer-dated, cross-asset, cross-geography client servicing and optimisation, plus the use of different legal structures such as 鈥榩ledge鈥�, will keep the market on its toes for the foreseeable future.
How will UMR affect the collateral marketplace?
Murray: UMR has already had a major affect on the industry. The first 4 phases are exchanging two-way regulatory IM, $170 billion across phase ones according to ISDA鈥檚 2018 year-end survey. Everyone has developed or implemented an IM model, mainly ISDA SIMM, and all have new processes, procedures, governance and regulatory oversight to contend with. Phases five and six are estimated to be much larger in terms of the number of impacted counterparty groups and they have to now decipher what they need to comply with, how they have to comply and whether they are able to utilise the monitoring aspects that the Basel Committee on Banking Supervision and International Organization of 网爆吃瓜 Commissions (BCBS-IOSCO) statement alluded to by acting diligently.
The business as usual day-to-day processing is critical to get right. It varies from the management of your liquidity and funding requirements, the servicing of the long box for regulatory IM purposes, the external relationships with the custodial agents through triparty or third-party and dispute management, which will span operations and risk teams. In the longer term, we should expect to see all organisations focusing on the collateral dynamic, putting more emphasis on pre-trade analytics, moving to step-change technological improvements and enhancing internal connectivity across front office teams and their support areas in risk, legal and operations to increase efficiency and garner a better understanding of costs and the subsequent allocation of those costs to the correct place.
Gomm: Since the 2008 financial crisis, regulators have made huge strides towards stabilising the global financial system via regulatory reform. The US Dodd-Frank Act, Basel III, the European Market Infrastructure Regulation (EMIR) and other global equivalents have provided a tidal wave of regulatory change which, in the current economic climate coupled with stressed market conditions, has exasperate institutions鈥� antiquated IT infrastructures, the lack of regulatory compliance, increased margin and dispute volumes, added to the adverse operational capacity, selection of IM calculation methodology and the subsequent squeeze on high grade collateral. However, institutions that were due to be impacted by UMR phase five, are now breathing a huge sigh of relief after the Basel Committee on Banking Supervision (BCBS) and IOSCO announced a one-year extension. Firms with an average aggregate notional amount of greater than 鈧�8 billion, but lower than the interim 鈧�50 billion threshold, will now be required to exchange IM in September 2021; 12-months later than the original mandated date. Many phase VI firms, particularly those domiciled in the US, will no longer be required to physically exchange daily IM with a large subsection being required to provide the underlying calculation of IM requirements only. However, streamlining IM requirements is much greater than purely choosing between schedule-based (GRID) IM and SIMM calculation methodology. Firms need to take a strategic, rather than tactical approach, thereby maximising automation, connectivity to triparty agents and CCPs, optimisation and efficient inventory management. This will ensure regulatory compliance, collateral mobilisation giving rise to competitive edge.
Allen: UMR will add complexity to firms in the over-the-counter derivatives market as they and their counterparties work to become compliant. This impacts legal, risk, treasury, front office and operations given the scope of the requirements. Those firms that have centralised collateral management and securities finance onto a single platform, such as Apex which supports the regulations, will be in an advantageous position. UMR will drive many firms into the securities lending market to access and use the assets needed for IM. Firms will be using systems that provide a central platform for securities finance and collateral, more and more. The decision to centralise these disciplines is both an organisational and an infrastructure question. We are all concerned about how regulations stop people getting on and doing their business. However, this regulation could paradoxically have a positive effect on securities finance.
Reece: I think the immediate impact, especially from the final phases, will be the significant time, effort and resources required across the industry to implement the rules efficiently. Given the scope and scale of participants in phases five and six, all industry participants will need to work together effectively. One of the longer-term benefits is likely to be increased interoperability between collateral providers, especially triparty agents, venues and vendors. As noted earlier, the final rule phases will also prompt a decision for buy-side firms. They can choose to implement a tactical solution to meet the requirements, or they can opt for future-proofing with a robust, end-to-end collateral optimisation solution across margin, liquidity and portfolio performance. Given ongoing pressures on spreads and shifting demand for liquidity, as well as the new margin obligations, choosing to work with firms who specialise in collateral, agency financing and lending solutions, with the expertise, scale and access they bring, is an increasingly attractive option. With the 2020 deadline fast approaching, buy-side firms should be deciding on their partners now.
Why should the firms aim for a centralised collateral management infrastructure?
Reece: Whatever the collateral obligation or opportunity firms are aiming to execute against, it鈥檚 important to have the broadest possible view and access across their portfolio. From a sell-side perspective, allocating collateral efficiently is now so much more complex, given the various capital, funding and liquidity constraints they are managing to - it鈥檚 not just a case of prioritising lower-quality collateral.
Considerations related to counterparty, house-versus-client activity and duration are all critical in allocating collateral efficiently versus a firm鈥檚 binding constraints. Being able to view a broad portfolio is key, but firms also need to be able to mobilise across business lines and time zones to access the collateral and then be able to allocate and lock into trades effectively. It鈥檚 impossible to manage this process efficiently in traditional product and business silos.
Allen: Centralising collateral management, securities lending and treasury management can greatly improve efficiency. A given pool of assets can be used in the repo market to gain cash for variation margin, it can be used to raise revenue in the securities lending market or it can be transformed to access the securities needed. Only if these decisions around allocations are centralised, can firms avoid the spreads of going externally to access what is needed and to ensure the inventory is allocated optimally across all requirements.
Gomm: Many organisations still operate separate collateral pools to manage margin. Often this means the structure does not enable margin netting and compression to realise collateral and cost efficiencies for revenue-generation opportunities and can result in sub-optimal use of collateral inventory. If you include bilateral margin calls and settlement liquidity, then there is potential to utilise your triparty collateral arrangements to service a wider pool of business needs. The ability to break-down product silos and provide a holistic, cross-product view of risk to optimise firm-wide collateral inventories gives rise to competitive advantages which are not only proving to be critical to the success of any institution but for the financial industry as a whole. Therefore, the belief is that a centralised collateral management infrastructure is critical and should be at the forefront of any solution provided by fintech companies.
Murray: There is a multitude of reasons all firms should be looking to centralise when they consider collateral; the two most important are connectivity and simplicity. The embedded and increased risk and costs of the collateral regulatory environment needs management. Being joined up internally and externally, understanding the impact that a particular role has upstream and downstream leads to a more open and transparent approach to the collateral chain, which automatically brings a more efficient way of operating. In turn, being efficient leads to reduced costs. From a connectivity perspective, you should be working on a real-time basis, which is far more conducive to risk and liquidity management and ultimately can improve the top-line metrics through better balance sheet and risk-weighted assets management.
Crowther: Consolidated, enterprise-wide solutions can offer better cost-effectiveness, improved business returns and a more controlled, scalable solution in terms of a firm鈥檚 target operating model.
What are the key challenges that organisations would face with this?
Crowther: The key to this is a firm鈥檚 ability to have the visibility and connectivity needed to view and action coverage, agree or dispute exposures and effect collateral mobilisation to cover margin calls and this relies on the ability to collaborate not only a firm鈥檚 counterparts but also its different infrastructure providers across different technologies.
The ecosystem is becoming much more complex 鈥� more products, more counterparties, more venues, more regulations 鈥� but standardised, automated technology should make the process of managing that growing spider web of complexity much easier.
The key points to enterprise-wide solutions are connectivity and real-time visibility 鈥� whether that be connecting with counterparties, infrastructure providers or utilities - firms should make sure they connect into that network to efficiently mobilise assets and agree on collateral. No firm can do that by themselves, they need to be outward-looking.
Allen: Building a business case for a budget for centralisation is a challenge. There is also an opportunity in regulatory deadlines for UMR and the 网爆吃瓜 Financing Transactions Regulation (SFTR), which do require firms to look at their collateral infrastructure. I would urge firms to use this opportunity not to just do the minimum for compliance but to look at their collateral and securities finance infrastructure and invest to realise the benefits of centralising and optimising across front middle and back office.
Murray: There are multiple challenges to a centralised infrastructure which starts with the investment of those scarce resources, time and money, both of which need to be supported by their friend, expertise. The first and most crucial stage is to define the problem statement: what problem are you solving? Who is going to be responsible for the centralised infrastructure, is there a 鈥榗ollateral owner鈥� with the autonomy to bring success to the organisation? Are they backed by multiple stakeholders supporting them across product, functional and geographical footprints? Which (whose) problems do you solve first? What do you want the end-point to look like? Will the scare resources stretch far enough? There are several ways to break this down into manageable chunks and that should be a key consideration for all, as we鈥榲e already recognised, collateral is rapidly evolving, some parts of the infrastructure are more important than others. Ultimately, organisations have the same challenges but they have a different priority weighting which needs to be understood at the outset.
Gomm: For years many firms have considered the move away from siloed processes. However, often such implementations can be costly, time-consuming and turn into multi-year projects. Many institutions still have antiquated infrastructures and internal data issues. Data quality and availability are a real issue throughout the industry and often represent the greatest risk to an organisation鈥檚 ability to operate a centralised collateral management infrastructure. Fortunately, there are fintech companies in the market place that are offering truly cross-product solutions. These solutions are geared towards both sell and buy-side organisations, providing hosted or a cloud-based infrastructure that removes the technical burdens and enables real cost and efficiency benefits.
Reece: For most firms, the main challenge is changing working practices and processes that developed over multiple years and have previously worked effectively. Aside from considerations around the front office, in terms of competing strategies, profit and loss (P&L) and balancing firm and individual desk priorities, the key challenge is often managing operations and heritage technology stacks.
Technology can pose a particular problem: for example, when we look at fixed income and equities business lines, the technology and associated downstream processing has often grown up in completely separate business lines. Realigning back, middle and front offices priorities within an already challenging market environment is a big decision, although the long term benefits are clear. To be effective, the role and responsibility for centralised collateral management infrastructure generally needs to be mandated from the top of the house. The full benefits from optimisation and mobilisation solutions through triparty agents and the broader ecosystem are magnified as firms move to a centralised collateral management infrastructure, through both scale and efficiency.
What other regulations do firms have to contend with in this space?
Reece: SFTR and the Central 网爆吃瓜 Depositories Regulation (CSDR) are both significant requirements that firms need to prepare for ahead of 2020. We shouldn鈥檛 underestimate the amount of work required or the impact of not being properly prepared, but there are clearly longer-term benefits to consider. I referenced the industry鈥檚 growing focus on consistent data standards, harmonised markets and interoperability, but the reality is it鈥檚 often very difficult to drive this purely as an industry initiative.
Regulation is often the catalyst for firms to prioritise funding and resources to an initiative, and so requirements from SFTR and CSDR will almost certainly deliver significant advances in data consistency, standardised reporting and harmonised markets. The timing of the International 网爆吃瓜 Lending Association鈥檚 鈥楢genda for Change鈥� whitepaper and suggested 鈥榗ommon domain model鈥� are also well placed to help maximise benefits in this area.
Crowther: The European 网爆吃瓜 and Markets Authority/EMIR are creating greater complexity by requiring collateral segregation and enforcing stricter eligibility requirements, BCBS is mandating improved liquidity profiles, greater capital buffers, more cleared products and higher-margin thresholds, SFTR and CSDR will affect collateral liquidity and widen market spreads whilst various government programmes such as quantitative easing and UCITS IV continues to impact availability of HQLA.
Murray: In Europe, you have SFTR, which has been front-and-centre of industry and media discussions for well over 12-months, unfortunately, that doesn鈥檛 seem to have materialised in an advanced state of readiness across the industry when you consider planning and execution. CSDR regulation hasn鈥檛 had the same fanfare that we have seen for SFTR or UMR, but firms who underestimate its impact, in particular, the settlement discipline regime which is due in 2020 could be in for a shock.
Additionally, in the EU we await clarification on the EMIR Refit and the requirements for IM model approval which are expected to be proportionate to the size of the firm, the larger you are the more onerous it will get.
For the Interbank Offered Rate purposes BCBS-IOSCO recently stated that if you鈥檙e amending legacy derivative contracts solely to address interest rate benchmark reforms then you are not required to apply margin requirements for UMR. Assuming this position receives regulatory support, it means firms will have to have a systematic and automated way of ensuring such trades do not pollute their IM calculations. Documentation wise, credit support annexe or central securities depositories referencing the London Interbank Offered Rate or equivalent rates will need to be identified and have some form of an amendment or ISDA protocol executed.
Does liquidity scarcity exist or do you just have to know where to look?
Reece: While there are always conversations about liquidity, market feedback suggests that you just need to know where to look and/or have the capability to transform assets as required.
Gomm: It certainly exists as UMR represents a regulatory landscape, the likes of which have never been seen before, which has the collateral pool shuddering at the concept of an unprecedented demand for collateral comprised of high-grade assets and an increase in haircut provisions. While it is noted that increased collateral requirement in the market means greater safeguards against default, conversely, the ever-increasing demand for high-grade collateral also has an inherent destabilising market factor. Buy-side institutions have limited access to large inventories of high-grade collateral which gives rise to the phenomenon known as a 鈥渃ollateral scarcity鈥�. However, historically back off domiciled processes are now becoming key drivers of P&L. Sell-side firms can capitalise on the need for transformation and Secured financing services.
Secured finance transactions and post-trade optimisation techniques are fundamental to the provision of an untapped global inventory of high-grade collateral to smaller institutions and buy-side clients, while simultaneously providing sell-side institutions with further profitable business and revenue streams. Therefore, access to high-quality collateral positions via secured finance transactions and post-trade optimisation strategies coupled with competitive edge gained from technological efficiencies, are vital to market liquidity and thus the elimination or easing of the collateral scarcity phenomenon.
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