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Cracking the Collateral Optimization Question: Principles, Planning, Technology

An estimated 40-50% of OTC contracts are expected to be cleared by the end of 2013, leaving a $2.5 trillion collateral hole to fill. This will drive firms to optimize their internal inventory while simultaneously engaging with custodians, dealers, and settlement houses offering collateral transformation services, according to a new report, Cracking the Trillion Dollar Collateral Optimization Question: Defining Principles, Strategic Planning, and Technology, from Celent, an international financial research and consulting firm.

Key findings of the report include:

• Many organizations including custodians, dealers, and settlement houses are looking to offer collateral transformation or collateral upgrade services to their clients. However, these external service providers cannot do unlimited amounts of collateral transformation; these firms will have to ensure they are optimizing their assets against their own requirements but also have the infrastructure in place to support optimization services offerings to their clients via client clearing services.

• There is one question that is on the lips of a number of practitioners in these markets: Where is all this collateral going to come from? The collateral and margin requirements across the various markets mean that there would be a requirement for vast amounts of (relatively) good quality collateral.

• As we move towards a scenario in which central clearing of standardized OTC derivatives becomes the norm in markets across the globe, current-generation approaches to collateral optimization (e.g., merely at business unit level, or based on "one dimensional") and hard-wired optimization algorithms (e.g., cheapest to deliver) will no longer suffice. When done correctly, firms can optimize collateral across often siloed front office organizations.

• The two main collateral management issues firms face today are collateral allocation and collateral optimization. Firms have collateral held in different offices, through various instruments, by different people with divergent agendas, one being traders that strive to achieve the best trades/results, the other being risk managers that work to keep the firms safe and out of risks' way. This process is overcome by collateral allocation, which is done by taking an inventory of all collateral the firm has in place and integrating it with an enterprise infrastructure across the front, middle, and back office. The more challenging issue firms face is internally planning the best value (risk management or trading/profitability) decision process for the collateral or collateral optimization.

• Strategic collateral optimization is internally planning the best value (i.e., risk management or trading/profitability) decision process for the collateral pledged and held. This can be done through Credit Support Annex (CSA) renegotiation, improvements in inventory management to identify the cheapest-to-deliver assets, or much more refined initiatives where firms have clearly identified an opportunity in which strategic margin management can contribute to the front office's P&L.

• A strategic approach to collateral optimization needs to translate into and take into account the optimization of the risk and capital in order to achieve an overall payoff. This is in the context of a firm needing to triangulate the "correct" financial levers within the firm - risk-weighted assets / risk capital, funding costs, and use of balance sheet. Arguably, for most firms, the journey has begun, but there is still a long road ahead.