Global and domestic financial firms today fully understand that the world has changed. The financial crisis provoked a wave of complex, sometimes contradictory, and still unfinished rules and regulations. The result has been a global squeeze on collateral, prompting new demand for more efficient and cost-effective collateral management (CM) tools and processes delivered through an integrated operating model.
Collateral management (CM) has abruptly emerged from its former, fragmented, and neglected back-office status to become a critical part of financial institutions’ business strategies. The web of new regulations is creating a scarcity of quality collateral estimated at anywhere from $800 billion (Bank of England) to $4 trillion (the International Swaps and Derivatives Association) to as much as $10 trillion (Bank for International Settlements). Whatever the real number is, the new challenges of cost-effective, transparent, efficient collateral management require new digital strategies to cope with rapidly changing rules and regulations. At the same time, meeting these challenges effectively can significantly increase liquidity and access to collateral, decrease transaction costs, offer valuable insight into trading and other business operations, and even create an entirely new profit center for many financial institutions.
Integrated collateral management is now critical for effective liquidity risk management. As banks and other institutions move to boost their returns on equity and deal with a disappearing market for unsecured transactions, they will need more effective tools, systems, and methodologies to maximize their ability to manage collateral for optimal value.
Genpact estimates that billions of dollars are being left on the table each year globally because of fragmented, opaque, outmoded, and otherwise inadequate collateral management strategies. A recent Oliver Wyman/SWIFT study projected that new initial margin requirements would exceed $1 trillion by 2018 and that eligible collateral assets currently lying dormant must be unlocked1. Regulatory changes will only complicate and intensify the need for more secured financing for longer periods of time, the need for accurate assessments of inventory and the total cost of collateral transactions, and therefore the necessity of optimizing collateral management.
New requirements that affect collateral liquidity include the following:
- Increased capital adequacy requirements such as higher capital levels and better balance sheet quality and a longer, broader list of risks to be covered, particularly for firms deemed systematically important financial institutions (SIFIs)
- Capital conservation and countercyclical capital buffers
- New absolute leverage ratios to respond to failures of risk models
- A liquidity coverage ratio that ensures institutions can handle a 30-day liquidity stress event
- A net stable funding ratio that ensures more solid funding strategies and better matches assets with liabilities
- Increased demands for improved transparency, including more reliable risk data and more detailed reporting
Root of the problem
Institutions, therefore, face various margin and collateral management challenges depending on the present operations practices and governance structures. Global investment banks, for instance, are more likely to have assessed the complexities and uncertainties of their operational environments and developed a holistic view of collateral asset classes. However, domestic institutions, despite a more narrow geographic reach and simpler business model, may nevertheless have neglected their margin and collateral management systems and strategies.
Regardless of an institution’s size and focus, organizational fragmentation and silos are common problems. Institutions may centralize or divide collateral management by functions or business units, but the most common models do not create data sharing, or an integrated, comprehensive view of margin, risk, liquidity, and asset inventories, which creates a barrier to integrated collateral management. Most important, institutions may have no single analytic tool or repository for storing and analyzing the flood of regulations and transaction rules that can affect and degrade optimal collateral management.
This division may also create inadequate, disparate internal transfer pricing mechanisms and the inability to perform accurate inventory assessments and projections. It may create excessive costs associated with moving collateral between business units or pools, added staffing requirements, and new IT interfaces that otherwise would not be needed.
Assessing the requirements of an effective CM program
Institutions are being forced to recognize that CM is central to optimal balance sheet management, and must be run in close collaboration with trading, treasury, risk and liquidity management, capital optimization, and portfolio management. This means an insightful management process must be directed at the broadest possible range of assets, including equities, fixed income, loans, commodities, and cash.
The collateral management process must implement a holistic, enterprise-wide collateral management system that includes an integrated IT solution that offers a complete overview of asset classes, business, and legal units. Such a system would allow CM across business lines, asset classes, and even corporate legal entities. It would facilitate or enhance internal transfer pricing mechanisms that efficiently display the relative value of collateral in a cohesive and timely manner. Such a CM operation would develop accurate credit and counterparty exposure calculation engines that would show potential future exposures.
In addition, any effective CM optimization program must create a centralized responsibility for liquidity and collateral management that reconciles traditional conflicting division or departmental objectives. Front-office secured funding desks are usually looking to maximize profits, for example, while treasury divisions often manage liquidity for maximum flexibility that can inflate the number and range of providers and liquidity pools.
Finally, an effective CM system must aggregate collateral data by asset classes, locations, encumbrances, and currency. The CM system must provide sufficient detailed data to meet business, counterparty, and service provider needs. And the system must develop timely and effective connections and inter-operability with providers to move collateral efficiently.
The new standard: Integrating margin and CM programs
Real-time margin management and intra-day CM are now business basics for financial service firms. In order to thrive, firms must:
- Manage dynamic margin and collateral eligibility rules
- Manage collateral in real time across multiple counter parties, settlement systems, exchanges, and clearing venues with diverse requirements, including different CCP margin models
- Ensure liquidity and funding capacity by optimizing the collateral supply chain
- Capture, mitigate, and allocate collateral costs across products and businesses
To effectively develop these capabilities, a firm must first have a centralized margin and collateral rule book that offers dynamic and on-demand data. This should be a central database that contains all counterparty margin processing and collateral eligibility rules derived from any counterparty agreement that requires margin and collateral exchanges. It should be agile, with the capacity to accept frequent modifications that refresh the database and the firm’s own risk weighted asset (RWA) rules for collateral eligibility.
Integrated CM and margin management also requires a cross-business, cross-asset class centralized collateral inventory system that can display on-demand collateral availability, including inbound collateral to be received from counterparties. The underlying principle is somewhat similar to just-in-time inventory management across the supply chain. The supply must meet the demand in as close to real time as is possible. A firm needs tools for the capacity and scale required to optimize collateral management and pre-trade analytics and to properly allocate collateral costs.
A recent survey described the difficulties firms face in attempting to manage collateral and liquidity across multiple silos and inventory systems: “The flows in the collateral-liquidity area can be described as chaotic”2. Consider the potential cost and operational efficiency savings from replacing multiple, siloed systems with an integrated, enterprise-wide platform and rulebook. For the firm and its clients, a single integrated system would allow collateral and margin managers to tap quickly into the vast amounts of data contained in collateralized agreements and counterparty rules. This is the basis for getting the highest and best use of a collateral inventory. The system would offer an enterprise-wide view of what a firm has, plus the accompanying rules that would allow that firm to quickly value and assess the appropriate value for any given asset.
Implementing a holistic solution
Regardless of whether the system is delivered internally or through a vendor, any good and reliable solution must enable buy and sell-side firms to integrate disparate systems and automatically capture, digitize, and process the agreements data. Vendors have also begun to realize the pressing need to invest in collateral management solutions and develop capabilities to meet customer expectations. An example of such investment is Genpact’s Collateral Agreement and Reference Data Services (CARDS). Keeping at helm the pressing need to have a reliable collateral management solution, CARDS enables a streamlined collateral management process by digitizing and integrating the data with counterparty and security reference data and central counterparty (CCP) margin models as well as enterprise-wide collateral inventory sourced from systems across different lines of business.
By using a platform such as CARDS, which has the intelligence to recognize and digitally extract these rules, firms avoid the need for excessive manual data entry, which can be expensive and time-consuming. In some cases, an institution may find that a combination of solutions is required to ensure they are truly upgrading their CM program. For instance, the combination of state-of-the-art reference data management tools such as CARDS with a collateral inventory management platform can allow firms to realize greater cost savings, efficiency gains, and operational and credit risk mitigation through a streamlined margin and collateral management process that encompasses the entire financial enterprise. To achieve further gains in cost savings and efficiencies, consideration of what operational functions can be outsourced to third-party service providers and what functions need to be retained for risk, control, and compliance by the institution is the logical next step.
As the business landscape changes, institutions will require an increasingly integrated IT solution to modernize their CM program. Institutions must continue exploring various vendors and outsourcing solutions as well as in-house enhancements in order to find the best, most efficient way of conducting their CM programs.
An amended version of this white paper was accepted for publication in the Journal of Securities Operations & Custody, Volume 9, Number 1, December 2014. The journal is published by Henry Stewart Publications, London. http://www.henrystewartpublications.com/jsoc
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- The Capital Markets Industry: The times they are a-changin’ http://www.oliverwyman.de/media/The_Capital_Markets_Industry_-_The_Times_They_are_A-Changin.pdf
- Collateral Optimization: The value chain of collateral: Liquidity, Cost and Capital Perspectives http://www.clearstream.com/blob/66616/9250c222407c9aad032ff51f8e4befa3/eltonpickford-data.pdf