Collateral management in 2021
19 November 2020
Delays to the Uncleared Margin Rules until 2021 does not mean the problem has gone away. Now is the time to focus on your collateral management processes, and FIS can help
Image: Ted Allen
Let’s start with some good news: 2020 is nearly gone and next year we can hopefully look forward to enjoying all those things that didn’t happen this year. Just think what we might get in 2021: a COVID-19 vaccine, the Tokyo Olympics, an Ashes series, a Ryder Cup, a couple of rovers on Mars and the United Nations’ International Year of Peace and Trust. It’s not all good news of course. We can also expect a plague of locusts (well, cicadas really – check out Brood X), the end of Moore’s Law, a return to commuting and wave five of the Uncleared Margin Rules (UMR). This being the collateral management issue of SFT, we will focus our attention on that last point and some related predictions for the year ahead that are driving FIS’ strategies.
When the UMR delay was first announced, many in the industry breathed a small sigh of relief. At least that was one less problem to deal with in this car crash of a year. Of course, the problem didn’t go away, it was just kicked down the road to be dealt with when things have settled down and we have all got back to normal. Normality, though, will take longer to return than many of us expected, so we will have to deal with the alternative reality. UMR projects that were summarily put on hold in early 2020 are now starting up again in earnest.
Those firms in wave five of UMR are now seriously engaging in preparations and are following five key steps. One: identifying when they are in scope; two: identifying which of their counterparties is in scope; three: working out their strategy for custody (third-party custodian or triparty); four: negotiating the legal documentation with their custodian and their counterparties; and five: upgrading their capabilities to calculate the standard initial margin model and exchange collateral.
Given the pre-pandemic predictions that there was a widespread lack of preparation and many firms wouldn’t be able to comply with the regulations by the original deadline, the delay is helpful. The industry has had more time to prepare and fewer will run the risk of not complying by September 2021. Another benefit we are seeing from numerous clients is that the goal of the preparations has moved from doing the minimum tactically to taking a more strategic approach. Not just how to comply, but how to use this as an opportunity to implement fundamental improvements.
The delay is hailed by operations teams because it has allowed them to concentrate on improving business-as-usual. Mass working from home showed the benefits of automation in a model where there is less ad-hoc communication between colleagues in the office environment. The big swings in volumes and values of margin calls in the early days of lockdown put a huge strain on collateral managers and highlighted the value of an automated straight-through process. Firms have also had the time to make more strategic decisions about how they will adapt their operations to wave five, and they have had a preview of what the extra volumes will do to their business process. They have been able to understand the pinch points and get better insight into what they will need.
As an example, the over-the-counter (OTC) derivatives market saw an 80 percent increase in margin calls in March and was settling down to around 20-25 percent higher in April, May and beyond. This created tension, as firms grappled with the extra volume, whilst adapting to staff working from home.
Another pandemic pinch-point has been a slight increase in the prevalence of collateral settlement fails. Fails typically have one of four potential causes: incorrect SSIs, technology shortcomings, insufficient collateral on hand or counterparty insolvency. The first two can be alleviated with investment in collateral management technology to streamline the operational processes. The problem of insufficient collateral can be mitigated by investing in central inventory management and collateral optimisation to mobilise a greater pool of assets. Unfortunately, there isn’t an easy technology solution to counterparty insolvency, but integrated cross-asset collateral management across the silos can act as the canary in the coalmine. A counterparty disputing, failing or delaying a collateral move can be an indicator of liquidity problems. Combining collateral management across products has helped. Those firms that have centralised the collateralisation across OTC and listed derivatives and combined this with the securities finance business have a good view on the overall client situation and are better able to identify and deal with problems quickly. Identification of the problem is best done early, and an integrated collateral process will pick this up sooner than if a firm is operating in silos.
Addressing these issues through strategic investments in technology and operations will make the wave 5 implementation smoother.
The delay has also given time to prepare strategically for solving the problem of how to minimise the impact of higher collateral requirements from the exchange of initial margin under UMR. The size of the collateral movements during the pandemic increased even more than the number of calls – on average, there was a two to five-fold increase in the size of margin calls across market participants. That’s a useful preview of what will happen when wave five hits. There are essentially two approaches to this, which should operate in tandem: margin optimisation and inventory optimisation. When combined, they are effective tools to reduce the overall cost of collateral.
Margin optimisation tools help with reducing the amount of collateral required to achieve the desired risk profile. Margin optimisation analytics simulate the impact of a new trade across the various counterparty or clearing options to identify the best overall counterparty based on existing portfolios and the margin impact. This is another arrow in the traders’ quiver.
Inventory optimisation tools are used to maximise a firm’s use of their inventory to ensure that they have enough of the right quality of assets, in the right place, at the right time. Combining collateral management with securities finance and liquidity management means firms have a single decision-making point about how to allocate their inventory to collateral requirements, capital requirements, liquidity and the securities lending program.
Inventory optimisation, however, is dependent on knowing what assets your firm has, where they are, who owns them, and where they can be used. Unfortunately, many firms are unable to view and allocate their global set of inventory positions across securities lending and borrowing, repo, outright buys and sells and cross-product collateral management. Position data is held across multiple silos of systems and geographies without a real-time view of actual depot balances or a single point of consolidation. Disparate systems used across business lines and locations means that data normalisation is also problematic without common standards. These problems have a direct impact on economic performance. Firms without this global view of inventory are unable to optimise the allocation of positions during normal day-to-day activity. The goals of optimisation are to:
• Maximise the returns from the securities lending programme
• Minimise the costs of cash and non-cash liquidity management
• Minimise the costs of allocating positions for cross-product collateral management requirements
• Minimise balance sheet impact of securities allocations across the various programmes
Moving from assumed settlement and end-of-day reconciliations to optimising inventory allocations across the firm in real time reduces operational risk and increases efficiency.
Considering some further trends for 2021, vendors and industry associations are working closely on initiatives like the International Swaps and Derivatives Association’s and International Íø±¬³Ô¹Ï Lending Association’s common domain models (CDM). These are standardised ways of representing and communicating data relating to OTC derivatives and securities finance trades that have good potential if widely adopted. Common standards can reduce inefficiencies from having multiple representations of the same data within a firm and across the market. CDM, together with digitisation of collateral agreements and collateral schedules, will help reduce the number of disputed collateral calls and increase the potential for optimisation of operations and inventory.
We can also expect artificial intelligence and machine learning to gain ground in securities finance and collateral in 2021. Standardisation of data will help. FIS is investing heavily in this space and we’re already seeing machine learning being used in repo, collateral management and securities lending to help traders decide when to borrow or lend and with whom to trade. Machine learning makes it easier to spot patterns and opportunities in liquidity and trading by looking at the behaviour of clients and trading partners. It can be used for collateral allocation decisions to influence where to allocate assets in the optimisation process. We also see applications of machine learning in determining settlement patterns for both cash and non-cash collateral. That means, firms can more accurately predict what settlements would likely fail or be delayed. This helps reduce the buffers needed for intraday liquidity management. There’s a substantial cost for banks – the use of smart tools can reduce those.
There are many pieces in the collateral puzzle and numerous providers offering bits and pieces that need to be stitched together. FIS is uniquely positioned to offer the whole end-to-end collateral management and securities finance value chain, from a single vendor and in the cloud. Our solutions can be deployed in-house, but we have seen a considerable uptick in demand for cloud deployment over the last few quarters. Simplicity, scale and reliability are compelling virtues. You may find Occam’s razor a useful maxim to finding a pragmatic optimal approach to collateral management.
The time and experiences gained in 2020 can be turned into opportunities for growth in 2021 and beyond. Now is the time to use that knowledge to drive investment and innovation and deal with what we know is around the corner.
When the UMR delay was first announced, many in the industry breathed a small sigh of relief. At least that was one less problem to deal with in this car crash of a year. Of course, the problem didn’t go away, it was just kicked down the road to be dealt with when things have settled down and we have all got back to normal. Normality, though, will take longer to return than many of us expected, so we will have to deal with the alternative reality. UMR projects that were summarily put on hold in early 2020 are now starting up again in earnest.
Those firms in wave five of UMR are now seriously engaging in preparations and are following five key steps. One: identifying when they are in scope; two: identifying which of their counterparties is in scope; three: working out their strategy for custody (third-party custodian or triparty); four: negotiating the legal documentation with their custodian and their counterparties; and five: upgrading their capabilities to calculate the standard initial margin model and exchange collateral.
Given the pre-pandemic predictions that there was a widespread lack of preparation and many firms wouldn’t be able to comply with the regulations by the original deadline, the delay is helpful. The industry has had more time to prepare and fewer will run the risk of not complying by September 2021. Another benefit we are seeing from numerous clients is that the goal of the preparations has moved from doing the minimum tactically to taking a more strategic approach. Not just how to comply, but how to use this as an opportunity to implement fundamental improvements.
The delay is hailed by operations teams because it has allowed them to concentrate on improving business-as-usual. Mass working from home showed the benefits of automation in a model where there is less ad-hoc communication between colleagues in the office environment. The big swings in volumes and values of margin calls in the early days of lockdown put a huge strain on collateral managers and highlighted the value of an automated straight-through process. Firms have also had the time to make more strategic decisions about how they will adapt their operations to wave five, and they have had a preview of what the extra volumes will do to their business process. They have been able to understand the pinch points and get better insight into what they will need.
As an example, the over-the-counter (OTC) derivatives market saw an 80 percent increase in margin calls in March and was settling down to around 20-25 percent higher in April, May and beyond. This created tension, as firms grappled with the extra volume, whilst adapting to staff working from home.
Another pandemic pinch-point has been a slight increase in the prevalence of collateral settlement fails. Fails typically have one of four potential causes: incorrect SSIs, technology shortcomings, insufficient collateral on hand or counterparty insolvency. The first two can be alleviated with investment in collateral management technology to streamline the operational processes. The problem of insufficient collateral can be mitigated by investing in central inventory management and collateral optimisation to mobilise a greater pool of assets. Unfortunately, there isn’t an easy technology solution to counterparty insolvency, but integrated cross-asset collateral management across the silos can act as the canary in the coalmine. A counterparty disputing, failing or delaying a collateral move can be an indicator of liquidity problems. Combining collateral management across products has helped. Those firms that have centralised the collateralisation across OTC and listed derivatives and combined this with the securities finance business have a good view on the overall client situation and are better able to identify and deal with problems quickly. Identification of the problem is best done early, and an integrated collateral process will pick this up sooner than if a firm is operating in silos.
Addressing these issues through strategic investments in technology and operations will make the wave 5 implementation smoother.
The delay has also given time to prepare strategically for solving the problem of how to minimise the impact of higher collateral requirements from the exchange of initial margin under UMR. The size of the collateral movements during the pandemic increased even more than the number of calls – on average, there was a two to five-fold increase in the size of margin calls across market participants. That’s a useful preview of what will happen when wave five hits. There are essentially two approaches to this, which should operate in tandem: margin optimisation and inventory optimisation. When combined, they are effective tools to reduce the overall cost of collateral.
Margin optimisation tools help with reducing the amount of collateral required to achieve the desired risk profile. Margin optimisation analytics simulate the impact of a new trade across the various counterparty or clearing options to identify the best overall counterparty based on existing portfolios and the margin impact. This is another arrow in the traders’ quiver.
Inventory optimisation tools are used to maximise a firm’s use of their inventory to ensure that they have enough of the right quality of assets, in the right place, at the right time. Combining collateral management with securities finance and liquidity management means firms have a single decision-making point about how to allocate their inventory to collateral requirements, capital requirements, liquidity and the securities lending program.
Inventory optimisation, however, is dependent on knowing what assets your firm has, where they are, who owns them, and where they can be used. Unfortunately, many firms are unable to view and allocate their global set of inventory positions across securities lending and borrowing, repo, outright buys and sells and cross-product collateral management. Position data is held across multiple silos of systems and geographies without a real-time view of actual depot balances or a single point of consolidation. Disparate systems used across business lines and locations means that data normalisation is also problematic without common standards. These problems have a direct impact on economic performance. Firms without this global view of inventory are unable to optimise the allocation of positions during normal day-to-day activity. The goals of optimisation are to:
• Maximise the returns from the securities lending programme
• Minimise the costs of cash and non-cash liquidity management
• Minimise the costs of allocating positions for cross-product collateral management requirements
• Minimise balance sheet impact of securities allocations across the various programmes
Moving from assumed settlement and end-of-day reconciliations to optimising inventory allocations across the firm in real time reduces operational risk and increases efficiency.
Considering some further trends for 2021, vendors and industry associations are working closely on initiatives like the International Swaps and Derivatives Association’s and International Íø±¬³Ô¹Ï Lending Association’s common domain models (CDM). These are standardised ways of representing and communicating data relating to OTC derivatives and securities finance trades that have good potential if widely adopted. Common standards can reduce inefficiencies from having multiple representations of the same data within a firm and across the market. CDM, together with digitisation of collateral agreements and collateral schedules, will help reduce the number of disputed collateral calls and increase the potential for optimisation of operations and inventory.
We can also expect artificial intelligence and machine learning to gain ground in securities finance and collateral in 2021. Standardisation of data will help. FIS is investing heavily in this space and we’re already seeing machine learning being used in repo, collateral management and securities lending to help traders decide when to borrow or lend and with whom to trade. Machine learning makes it easier to spot patterns and opportunities in liquidity and trading by looking at the behaviour of clients and trading partners. It can be used for collateral allocation decisions to influence where to allocate assets in the optimisation process. We also see applications of machine learning in determining settlement patterns for both cash and non-cash collateral. That means, firms can more accurately predict what settlements would likely fail or be delayed. This helps reduce the buffers needed for intraday liquidity management. There’s a substantial cost for banks – the use of smart tools can reduce those.
There are many pieces in the collateral puzzle and numerous providers offering bits and pieces that need to be stitched together. FIS is uniquely positioned to offer the whole end-to-end collateral management and securities finance value chain, from a single vendor and in the cloud. Our solutions can be deployed in-house, but we have seen a considerable uptick in demand for cloud deployment over the last few quarters. Simplicity, scale and reliability are compelling virtues. You may find Occam’s razor a useful maxim to finding a pragmatic optimal approach to collateral management.
The time and experiences gained in 2020 can be turned into opportunities for growth in 2021 and beyond. Now is the time to use that knowledge to drive investment and innovation and deal with what we know is around the corner.
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100% ON RETURNS If you invest in only one securities finance news source this year, make sure it is your free subscription to Íø±¬³Ô¹Ï Finance Times
