In what ways has collateral management changed in the previous few years?
The biggest change is that collateral management is now centre-stage, whereas before it was very much a back-office function. It used to be considered as not very important, but in the last two years it has really come to the forefront. A firm’s complete focus used to be on trading systems. Now, collateral trading and the collateral function have become the main focus.
The changes in collateral management are driven by the advent of a new regulatory regime. The two key regulations are the US Dodd-Frank Act and the European Market Infrastructure Regulation (EMIR), and both of them require OTC derivatives to be centrally cleared, with the clearing houses demanding collateral to hold in order to do so. This regulatory change was driven by the G20 countries, which expressed their opinions on the importance of clearing and collectively agreed to enforce it. Firms now realise that they have a considerable amount of collateral to find, collateral that they do not currently have, and this has become a major problem for them.
How could a shortage of collateral affect particular businesses such as repo and securities lending, and how can they overcome shortages?
There have been numerous estimates of the shortfall of high quality collateral across the market. Some of these estimates place the shortfall as high as $6 trillion. The Bank of England recently published its collateral demand model for swaps and credit default swaps, which indicates that around £0.5 trillion (approximately $800 billion) of additional collateral will be required. But that figure itself assumes normal market conditions. In volatile conditions, such as those that we saw in 2007 to 2008, central counterparties (CCPs) and others start calling for a much greater margin, and in those circumstances the extra collateral needed across the industry could be as high as $2.6 trillion.
In practice, no one knows how much more collateral will be needed, but I believe we can be fairly confident that the shortage may actually be in the trillions and not billions.
We think that this means the repo market will become much more proactive, as many more securities have the opportunity to become ‘special’ (meaning that there is specific short-term demand for them), enabling the repo trader to make more money from them. At the same time the market is also likely to become more stratified. Instead of an issue being either ‘special’, or ‘not special’, we think that there will be a more refined set of grades. Potentially, an issue may be defined as ‘a bit special’ or a ‘bit more special’, and as a result the market will become much more sensitive to the value of collateral.
For OTC markets, the cost of collateral will have to be factored in to the price of the deal. In other words, collateral pricing will need to be available pre-trade in the front office, meaning that market participants must make maximum use of the resources that are available to them. Not surprisingly, we are seeing most firms initiating some kind of collateral optimisation initiative. This has major implications for their operating models, and of course requires strong technology support.
How are firms that act across multiple product lines integrating collateral management into their operations?
Collateral management is already integrated into firms operations, but it’s not integrated across their operations, so most firms operate in silos. Silos are often organised by asset class, so in each area where you have a trading system, there will be a back-office operation system with a collateral function, often in a silo all of its own. For example, the futures business, the repo business and the prime brokerage business will all contain collateral, but they are not integrated. So you may have bonds in one, equities in another and cash in all three, but with no single view.
We see many initiatives being created to enable a single stock record, either physically or virtually. With this in place, firms should at least be able to see an integrated view of all their collateral, even if it’s not located in one place. If collateral in a firm is held in different places, and the newly formed central collateral function built around the prime brokerage unit can’t see the collateral executions, or what’s in New York or Singapore, then how can it possibly optimise its collateral?
What do you advise clients if they are unable to optimise their collateral due to geographical disparity?
We wish them luck! In practice though, they don’t really have a choice, unless they happen to have so much collateral that it doesn’t really matter. They have to come up with a business operating model that allows collateral to be used in the right place, in the right time zone, and be allocated against the right liabilities or risks. And this allocation has to take into account all of the eligibility, haircuts and fee structures that will vary by venue.
Collateral re-allocation has to be enabled in the operating model, in a highly efficient ‘follow-the-sun’ (if necessary) STP environment, with all the right profit and loss allocations in the right jurisdictions. There are also many constraints about what collateral can be moved between jurisdictions, so there are limits to how much optimisation can actually be achieved across geographies.
How is technological innovation shaping collateral management?
Technology vendors have certainly realised that this is a big opportunity. Some vendors began investing in product enhancements two or three years ago to accommodate collateral management. They started building much more sophisticated collateral management platforms that provide functionality such as: single stock record, sophisticated collateral management and collateral optimisation algorithms. These vendors are now reaping the rewards and winning competitive tenders from banks and CCPs.
Other vendors, some of whom have historically enjoyed significant market share in repo or stock borrow and lend, have been slower off the mark and are running the risk of losing market share and being left behind. But changing an enterprise collateral management system is not for the faint-hearted, it’s potentially a massive job. However, with very limited options, we are right now seeing many firms having to grasp the nettle and consider re-platforming.
But innovation is not restricted to the package vendors. For the last two years, the tier one banks have been spending $50 million or so a year on technology innovation to deliver the same business functions, but more usually on systems developed in-house. Because they started early, they have the foundations in place and are now well positioned to lead the market and retain their dominance. The second tier firms are struggling to catch up, and are often constrained to doing the minimum that is necessary to protect their customer franchise.
How are regulatory changes driving the need for technological solutions to collateral management problems?
The regulations have set out very specific requirements to be met by specific dates. For example, under Dodd-Frank and EMIR, customers will have a choice about whether they are happy for their collateral to be held in an omnibus account, which is cheaper to operate, or to be fully segregated, which is safer but more expensive.
If many large account managers opt for full segregation, the industry will have a major challenge in dealing with a proliferation of accounts that have to be mirrored through the broker, the CCP and the triparty agent. This can only be achieved by putting the right technology in place.
Are there any technological advances that you would like to see happening for your clients, but aren’t?
The issue is not lack of technological advance, but lack of take-up of the technology that is already available. There are plenty of advanced solutions that are available which cover most, if not all of the componentry that firms need in the new world of clearing and collateral.
There are three main constraints that have held back technology adoption. First is the huge expense that is involved in introducing a new collateral platform that touches so many parts of the bank’s infrastructure, plus the significant integration and testing costs. A second inhibitor has been uncertainty about the regulatory requirements. It is not uncommon for firms to hold back on investment until they are more confident that the regulations will actually be implemented, and indeed whether the initial dates will slip. Finally, many have held back because some of the detail is still not pinned down; however, this is no longer a valid excuse. These regulations will happen, and though the dates and details may change a little, enough is now known for projects to start. Anybody still holding back on these grounds will almost certainly miss the boat.
Unfortunately, there may also be a fourth emerging constraint on technology adoption: a lack of resources on the supply side. Customers are already signing contracts with vendors with good solutions, and vendors are allocating their ‘A teams’ to these prestigious projects. These projects are strategic to both the vendor and the buyer, but there are only so many ‘A teams’ to go around. Firms that are late to the party will still demand the vendor’s top team, but they simply won’t be available. We are already seeing some vendors being quite careful about what new opportunities they are willing to bid for.
In summary, by now firms should be designing their new business operating models and their target technology architectures, and they need a reasonably well-defined implementation roadmap, at least for 2013. As investment budgets are formed up and we enter the next financial year, execution projects need to be mobilised pretty quickly if firms are to deliver the technology that they will need to have in place during the course of 2013.
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