Evolving perspectives
28 March 2023
APAC markets are shifting to put collateral management at the forefront. Purtini Joshi, head of Collateral+ Asia Pacific business development at State Street, evaluates the evolving collateral space and how digital assets are adding new dimensions to the investment cycle
Image: Purtini Joshi
Collateral has become the fundamental pillar for managing capital, risk, financial stability and, more recently, generating alpha. An unprecedented focus on collateral management, brought about by the Global Financial Crisis and accelerated by regulatory reforms, has accomplished systemic risk reduction in capital markets.
The effectiveness of collateral in mitigating credit and liquidity risk was evidenced during the peak of COVID. The initial weeks of market panic triggered a monumental increase in collateral demands and provided an effective protection against defaults. However, a number of vulnerabilities emerged within firms that were regulation compliant but lacked automated processes. COVID-induced market uncertainties led to a significant increase in volatility, resulting in volume spikes and a downward pressure on asset valuations.
As an example of the challenges firms faced, in times of volatility the increase in margin calls and disputes placed further pressure on funding requirements. As lockdowns took over, workflows and manual processes that were based on fragmented information, with physical and organisational separation of roles, created further differences between market participant systems and exposed firms to incremental financial and counterparty risk.
Looking into 2023 and beyond, collateral automation continues to be the dominant theme in APAC as firms look beyond compliance and assess the efficiency of cost and operations. In the same vein, collateral optimisation is poised to move from a conceptual idea to concrete outcomes. These themes are hardly new to buy-side firms, having been persistently emphasised in response to regulation. However, as firms start to live the impact of regulation and are faced with evolving market conditions, they must rethink their approach to collateral.
Emerging trends in collateral management are changing the rules of the game impacting the present practices and assumptions. For one, the recent buzz around convergence of securities finance and derivatives has yet again underscored the importance of holistic collateral management. In addition, ESG narratives and distributed ledger technology (DLT) innovation are adding new dimensions to the investment cycle, including collateral management. As these ideas mature and are incorporated into the collateral function, firms should bear in mind that their ability to adapt to future capability will depend on the foundational blocks of automation and optimisation.
Trinity of collateral strategy
A reflection on COVID has reinforced the importance of automation across the collateral value chain — from margin agreement through to settlement. It has also highlighted the importance of optimisation and collateral transformation during periods of high market stress.
Arguably, automation and optimisation are fundamental blocks of any firm’s collateral strategy. Automation streamlines processes and reduces complexity, while optimisation helps to manage funding cost and asset utilisation. As collateral movements become dynamic, collateral management teams need to stay close to middle- and front-office activities. Where clients pledge securities, the middle office needs to track trading activity and monitor coupons and maturity dates. Equally, timely confirmation of settlement is of paramount importance, more so in volatile market conditions.
Counterparties want to ensure that the collateral is in place to cover daily mark to market and potential future exposure. In the run up to the last two phases of UMR, State Street worked extensively with clients to streamline and standardise collateral workflows to prepare them for an uptick in volume. State Street’s Collateral+ moved clients away from manual spreadsheets, custodian portals and email communication, and enabled integrated middle-office services, providing operations teams clear sight into the inventory of assets available for meeting obligations.
However, as the buy-side adapts to the new normal of the post-regulatory world, focus is visibly shifting to optimisation in response to frequency and value of collateral movements. Restricted by allocation mandates, local regulation, capital restrictions and sub-optimal infrastructure, firms have had to carefully consider the impact of collateral costs on investment performance. Typically, a firm would look to deploy existing unencumbered assets in the portfolio before going externally. Unfortunately, firms in APAC have not been able to derive maximum benefit from their assets due to a variety of factors. Strong preference for G7 currencies, being the most traded and liquid, has prevented APAC firms from using their domestic currency assets with cross-border counterparts.
In most cases, collateral posted in APAC currencies typically attracts a higher trade charge from banks that price trades higher due to liquidity constraints inherent in local assets. Local market infrastructure for mobilising cross-border collateral movements is restrictive and, where permissible, is typically confined to government bonds with varying settlement cycles across the markets. Cross-border counterparties often cite absence of local custodian banks as an obstacle.
Moreover, managing collateral processes across time zones is particularly challenging between cross-border counterparties and local market cut-offs at custodians. This has pushed APAC firms to review the costs associated with acquiring globally accepted assets and its impact on portfolio performance. Consequently, collateral transformation has become key to managing the supply of accepted collateral within the constraints of mandates, balance sheet restrictions and counterparty risk. An asset manager long in equities, which are in general ineligible as collateral, can lend them to a custodian bank in return for high quality government bonds.
Another visible change in APAC is the steady shift away from USD cash to securities. Through the best part of the last decade, portfolio managers were reliant on cash to meet variation margin, citing operational efficiency and pervasive low interest rates. This has started to shift. Rising interest rates have changed the cost of funding, thereby altering the preference for cash in favour of securities. As securities start to replace cash to prevent its drag on portfolio, it will become imperative to optimise the inventory of assets across variation margin and initial margin, if applicable. Operationally, collateral teams will need to manage timely settlements and substitutions in response to corporate actions.
Also important to note, UMR has brought collateral segregation into focus. Effective segregation prevents commingling and establishes robust protection for collateral under a legal framework. Much like their global peers facing UMR obligations, APAC firms have used existing custodian relationships to pledge collateral from the main account to segregated accounts. This process, also known as third-party segregation, by design, is inherently inefficient, expensive and operationally burdensome.
Segregation arrangements typically encumber assets by moving them to a bankruptcy remote location and allow limited re-use, materially impacting the collateral giver’s liquidity and financing decisions. Collateral selection is bilaterally agreed between counterparties and movements are self-instructed to the custodian. For a firm working within the constraints of a portfolio mandate, this approach restricts unimpeded asset mobilisation and substitution, fragmenting the collateral pool across margining counterparties.
Recognising these limitations, State Street added triparty services to its Collateral+ platform ahead of UMR Phase 5. Triparty allows for optimised collateral selection across all counterparty obligations utilising assets held in custody with State Street or externally. Collateral can be switched efficiently and is agnostic to the underlying transaction, which means OTC, securities lending and bilateral repo can leverage the same service.
Convergence of securities finance
Margining is converging with financing and collateral is at the intersection. The International Swaps and Derivatives Association’s (ISDA’s) efforts to bring securities finance transactions (SFTs) and derivatives under a Common Domain Model (CDM) and single ISDA Master Agreement promises to bring quantifiable benefits to market participants by expanding the netting set across securities financing and derivatives.
Creating greater flexibility as to how clients can deploy their inventory is now essential. For example, funds may trade repo and reverse repo, reinvest cash or use it for margin, portfolio securities can be transformed to higher-grade collateral or traded in swaps to hedge or enhance yields. These examples just scratch the surface of possibilities. However, in practice, systems and operations for derivatives, SFT products have been organised in silos, reflecting the different process and market practices associated with each product type. Consequently, collateral function — although ubiquitous across the product types — is also dispersed and siloed to cater to operational nuances and regulatory treatment.
Notwithstanding the differences, a good place to start is inventory aggregation and cross utilisation. Triparty lends well to buy-side firms who want to start making efforts towards convergence. Well established for margining repos and OTC alike, a triparty framework addresses the key challenges — eligibility, optimisation, substitution, legal framework and settlement. More importantly, in APAC, it can potentially mobilise underutilised assets in restricted APAC markets like Taiwan and South Korea by harmonising settlement infrastructure and facilitating the use of local currency securities to the pool of globally accepted assets.
Collateral and digital innovation
One of the reasons triparty has gained significant prominence in collateral management is due to its efficiency in effecting settlement finality for legal purposes. This is significant in ensuring irrevocable and unconditional access to collateral following bankruptcy or insolvency of a participant. In addition, triparty improves costs and operational efficiency by reducing friction typically observed in bilateral transactions.
However, it does require the collateral giver to maintain a fully funded long box by the physical movement of assets from custodians to triparty. DLT has the potential to address both. It can ease the prefunding by facilitating near real-time settlements between custodian and triparty. Collateral givers can fund the long box just in time, easing liquidity pressure and reducing cost of capital. In the same token, where collateral moves bilaterally between custodians of the counterparties, DLT can affect the settlements in near real time, reducing credit risk.
Another potential use case for DLT is in bringing regional assets trapped behind local infrastructure and foreign exchange controls to the global stage. As noted earlier, with the exception of a few, domestic assets in APAC are not widely accepted for collateral due to infrastructure limitations and liquidity concerns. DLT can provide an alternative path by enabling diversified assets mainstream, in turn improving liquidity. With the progressive shortening of settlement cycles, collateral is in the footsteps of real-time payments that were witnessed two decades ago. DLT has the potential to overcome the relatively clunky settlement and reconciliation processes in the custody chains to bring about real-time collateral settlement.
ESG
As the ESG agenda continues to evolve globally, the APAC region is set to catch up with peers in other regions. Adoption of ESG in APAC is in the infancy stage, with some jurisdictions leading the charge with enforcement of mandatory disclosures, while in others, penetration is low due to lack of a consistent framework.
Accelerating client demand is the prime driver for integrating ESG into the investment process, both pre- and post-trade. In the context of collateral, it is important for beneficial owners to have visibility to confirm that the collateral they receive is sustainable and that it is aligned with its own ESG metrics.
At present, there is no consistent measurement framework for screening ESG compliant collateral assets. The industry is expected to adopt bespoke solutions that cater to a firm’s specific criteria and relevant ESG parameters.
In APAC, firms who are starting out on their ESG journey generally look to exclude holdings of companies that exhibit poor governance or are known to pollute through their economic activities. However, the ESG journey is expected to expand well beyond negative inclusions and threshold limits to unfavourable sectors. Its impact on credit ratings has the potential to dynamically alter collateral haircuts to capture relevant market information. Increasingly complex ESG data and ratings from research providers will be incorporated in the technology platforms which require flexibility and open architecture. State Street’s Collateral+ platform provides access to ESG ratings from multiple resources, enabling clients to customise their approach.
State Street is also developing digital collateral schedules which allows dynamic changes to ratings and eligibility sets. A collateral receiver may set a minimum rating level, but this may be modified dynamically to reflect changing preferences and in response to market events.
Bringing it all together
Having emerged from two crisis events in recent years, both of which brought additional focus on collateral as a risk mitigant, there is a palpable shift in the industry to give the subject its due importance.
Automation, optimisation and segregation are fundamental to any firm’s collateral strategy and set the foundation to adapt and expand. As collateral requirements for margining and financing converge, incorporating ESG and digital assets frameworks, buy-side firms will need agility and foresight. With the exception of a few large firms in the region, most buy-side firms have modest technology spends. In the same token, administrative and operational burdens are onerous and distract asset managers from their daily tasks.
As firms start to revisit collateral management in the context of alpha generation, they need to be slick in the midst of complexity. Outsourcing is one way to transfer this complex yet strategically important function, which in recent years has become sophisticated in response to unrelenting regulatory pressure. It offers end-to-end capability, a variable cost structure and stays lockstep with regulatory changes.
State Street’s Collateral+ platform is a holistic and flexible solution combining services and technology platforms. It helps clients tackle operational challenges within their legacy systems, provides a straight-through processing (STP) workflow, fully integrating front-office funding through middle- and back-office functions. Underpinned by centralised inventory management and optimisation, it is connected to all major service providers and custodians through open market connectivity. State Street continually invests in capabilities to provide clients with access to best-in-class services.
The effectiveness of collateral in mitigating credit and liquidity risk was evidenced during the peak of COVID. The initial weeks of market panic triggered a monumental increase in collateral demands and provided an effective protection against defaults. However, a number of vulnerabilities emerged within firms that were regulation compliant but lacked automated processes. COVID-induced market uncertainties led to a significant increase in volatility, resulting in volume spikes and a downward pressure on asset valuations.
As an example of the challenges firms faced, in times of volatility the increase in margin calls and disputes placed further pressure on funding requirements. As lockdowns took over, workflows and manual processes that were based on fragmented information, with physical and organisational separation of roles, created further differences between market participant systems and exposed firms to incremental financial and counterparty risk.
Looking into 2023 and beyond, collateral automation continues to be the dominant theme in APAC as firms look beyond compliance and assess the efficiency of cost and operations. In the same vein, collateral optimisation is poised to move from a conceptual idea to concrete outcomes. These themes are hardly new to buy-side firms, having been persistently emphasised in response to regulation. However, as firms start to live the impact of regulation and are faced with evolving market conditions, they must rethink their approach to collateral.
Emerging trends in collateral management are changing the rules of the game impacting the present practices and assumptions. For one, the recent buzz around convergence of securities finance and derivatives has yet again underscored the importance of holistic collateral management. In addition, ESG narratives and distributed ledger technology (DLT) innovation are adding new dimensions to the investment cycle, including collateral management. As these ideas mature and are incorporated into the collateral function, firms should bear in mind that their ability to adapt to future capability will depend on the foundational blocks of automation and optimisation.
Trinity of collateral strategy
A reflection on COVID has reinforced the importance of automation across the collateral value chain — from margin agreement through to settlement. It has also highlighted the importance of optimisation and collateral transformation during periods of high market stress.
Arguably, automation and optimisation are fundamental blocks of any firm’s collateral strategy. Automation streamlines processes and reduces complexity, while optimisation helps to manage funding cost and asset utilisation. As collateral movements become dynamic, collateral management teams need to stay close to middle- and front-office activities. Where clients pledge securities, the middle office needs to track trading activity and monitor coupons and maturity dates. Equally, timely confirmation of settlement is of paramount importance, more so in volatile market conditions.
Counterparties want to ensure that the collateral is in place to cover daily mark to market and potential future exposure. In the run up to the last two phases of UMR, State Street worked extensively with clients to streamline and standardise collateral workflows to prepare them for an uptick in volume. State Street’s Collateral+ moved clients away from manual spreadsheets, custodian portals and email communication, and enabled integrated middle-office services, providing operations teams clear sight into the inventory of assets available for meeting obligations.
However, as the buy-side adapts to the new normal of the post-regulatory world, focus is visibly shifting to optimisation in response to frequency and value of collateral movements. Restricted by allocation mandates, local regulation, capital restrictions and sub-optimal infrastructure, firms have had to carefully consider the impact of collateral costs on investment performance. Typically, a firm would look to deploy existing unencumbered assets in the portfolio before going externally. Unfortunately, firms in APAC have not been able to derive maximum benefit from their assets due to a variety of factors. Strong preference for G7 currencies, being the most traded and liquid, has prevented APAC firms from using their domestic currency assets with cross-border counterparts.
In most cases, collateral posted in APAC currencies typically attracts a higher trade charge from banks that price trades higher due to liquidity constraints inherent in local assets. Local market infrastructure for mobilising cross-border collateral movements is restrictive and, where permissible, is typically confined to government bonds with varying settlement cycles across the markets. Cross-border counterparties often cite absence of local custodian banks as an obstacle.
Moreover, managing collateral processes across time zones is particularly challenging between cross-border counterparties and local market cut-offs at custodians. This has pushed APAC firms to review the costs associated with acquiring globally accepted assets and its impact on portfolio performance. Consequently, collateral transformation has become key to managing the supply of accepted collateral within the constraints of mandates, balance sheet restrictions and counterparty risk. An asset manager long in equities, which are in general ineligible as collateral, can lend them to a custodian bank in return for high quality government bonds.
Another visible change in APAC is the steady shift away from USD cash to securities. Through the best part of the last decade, portfolio managers were reliant on cash to meet variation margin, citing operational efficiency and pervasive low interest rates. This has started to shift. Rising interest rates have changed the cost of funding, thereby altering the preference for cash in favour of securities. As securities start to replace cash to prevent its drag on portfolio, it will become imperative to optimise the inventory of assets across variation margin and initial margin, if applicable. Operationally, collateral teams will need to manage timely settlements and substitutions in response to corporate actions.
Also important to note, UMR has brought collateral segregation into focus. Effective segregation prevents commingling and establishes robust protection for collateral under a legal framework. Much like their global peers facing UMR obligations, APAC firms have used existing custodian relationships to pledge collateral from the main account to segregated accounts. This process, also known as third-party segregation, by design, is inherently inefficient, expensive and operationally burdensome.
Segregation arrangements typically encumber assets by moving them to a bankruptcy remote location and allow limited re-use, materially impacting the collateral giver’s liquidity and financing decisions. Collateral selection is bilaterally agreed between counterparties and movements are self-instructed to the custodian. For a firm working within the constraints of a portfolio mandate, this approach restricts unimpeded asset mobilisation and substitution, fragmenting the collateral pool across margining counterparties.
Recognising these limitations, State Street added triparty services to its Collateral+ platform ahead of UMR Phase 5. Triparty allows for optimised collateral selection across all counterparty obligations utilising assets held in custody with State Street or externally. Collateral can be switched efficiently and is agnostic to the underlying transaction, which means OTC, securities lending and bilateral repo can leverage the same service.
Convergence of securities finance
Margining is converging with financing and collateral is at the intersection. The International Swaps and Derivatives Association’s (ISDA’s) efforts to bring securities finance transactions (SFTs) and derivatives under a Common Domain Model (CDM) and single ISDA Master Agreement promises to bring quantifiable benefits to market participants by expanding the netting set across securities financing and derivatives.
Creating greater flexibility as to how clients can deploy their inventory is now essential. For example, funds may trade repo and reverse repo, reinvest cash or use it for margin, portfolio securities can be transformed to higher-grade collateral or traded in swaps to hedge or enhance yields. These examples just scratch the surface of possibilities. However, in practice, systems and operations for derivatives, SFT products have been organised in silos, reflecting the different process and market practices associated with each product type. Consequently, collateral function — although ubiquitous across the product types — is also dispersed and siloed to cater to operational nuances and regulatory treatment.
Notwithstanding the differences, a good place to start is inventory aggregation and cross utilisation. Triparty lends well to buy-side firms who want to start making efforts towards convergence. Well established for margining repos and OTC alike, a triparty framework addresses the key challenges — eligibility, optimisation, substitution, legal framework and settlement. More importantly, in APAC, it can potentially mobilise underutilised assets in restricted APAC markets like Taiwan and South Korea by harmonising settlement infrastructure and facilitating the use of local currency securities to the pool of globally accepted assets.
Collateral and digital innovation
One of the reasons triparty has gained significant prominence in collateral management is due to its efficiency in effecting settlement finality for legal purposes. This is significant in ensuring irrevocable and unconditional access to collateral following bankruptcy or insolvency of a participant. In addition, triparty improves costs and operational efficiency by reducing friction typically observed in bilateral transactions.
However, it does require the collateral giver to maintain a fully funded long box by the physical movement of assets from custodians to triparty. DLT has the potential to address both. It can ease the prefunding by facilitating near real-time settlements between custodian and triparty. Collateral givers can fund the long box just in time, easing liquidity pressure and reducing cost of capital. In the same token, where collateral moves bilaterally between custodians of the counterparties, DLT can affect the settlements in near real time, reducing credit risk.
Another potential use case for DLT is in bringing regional assets trapped behind local infrastructure and foreign exchange controls to the global stage. As noted earlier, with the exception of a few, domestic assets in APAC are not widely accepted for collateral due to infrastructure limitations and liquidity concerns. DLT can provide an alternative path by enabling diversified assets mainstream, in turn improving liquidity. With the progressive shortening of settlement cycles, collateral is in the footsteps of real-time payments that were witnessed two decades ago. DLT has the potential to overcome the relatively clunky settlement and reconciliation processes in the custody chains to bring about real-time collateral settlement.
ESG
As the ESG agenda continues to evolve globally, the APAC region is set to catch up with peers in other regions. Adoption of ESG in APAC is in the infancy stage, with some jurisdictions leading the charge with enforcement of mandatory disclosures, while in others, penetration is low due to lack of a consistent framework.
Accelerating client demand is the prime driver for integrating ESG into the investment process, both pre- and post-trade. In the context of collateral, it is important for beneficial owners to have visibility to confirm that the collateral they receive is sustainable and that it is aligned with its own ESG metrics.
At present, there is no consistent measurement framework for screening ESG compliant collateral assets. The industry is expected to adopt bespoke solutions that cater to a firm’s specific criteria and relevant ESG parameters.
In APAC, firms who are starting out on their ESG journey generally look to exclude holdings of companies that exhibit poor governance or are known to pollute through their economic activities. However, the ESG journey is expected to expand well beyond negative inclusions and threshold limits to unfavourable sectors. Its impact on credit ratings has the potential to dynamically alter collateral haircuts to capture relevant market information. Increasingly complex ESG data and ratings from research providers will be incorporated in the technology platforms which require flexibility and open architecture. State Street’s Collateral+ platform provides access to ESG ratings from multiple resources, enabling clients to customise their approach.
State Street is also developing digital collateral schedules which allows dynamic changes to ratings and eligibility sets. A collateral receiver may set a minimum rating level, but this may be modified dynamically to reflect changing preferences and in response to market events.
Bringing it all together
Having emerged from two crisis events in recent years, both of which brought additional focus on collateral as a risk mitigant, there is a palpable shift in the industry to give the subject its due importance.
Automation, optimisation and segregation are fundamental to any firm’s collateral strategy and set the foundation to adapt and expand. As collateral requirements for margining and financing converge, incorporating ESG and digital assets frameworks, buy-side firms will need agility and foresight. With the exception of a few large firms in the region, most buy-side firms have modest technology spends. In the same token, administrative and operational burdens are onerous and distract asset managers from their daily tasks.
As firms start to revisit collateral management in the context of alpha generation, they need to be slick in the midst of complexity. Outsourcing is one way to transfer this complex yet strategically important function, which in recent years has become sophisticated in response to unrelenting regulatory pressure. It offers end-to-end capability, a variable cost structure and stays lockstep with regulatory changes.
State Street’s Collateral+ platform is a holistic and flexible solution combining services and technology platforms. It helps clients tackle operational challenges within their legacy systems, provides a straight-through processing (STP) workflow, fully integrating front-office funding through middle- and back-office functions. Underpinned by centralised inventory management and optimisation, it is connected to all major service providers and custodians through open market connectivity. State Street continually invests in capabilities to provide clients with access to best-in-class services.
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