While regulation increases collateral needs, particularly as the derivatives market moves toward central clearing, market participants are cobbling together fragmented systems, manual processes, and siloed approaches to ensure compliance, creating significant inefficiencies.
In a recent survey by Sapient Global Markets (see Box), only 45% of market participants felt strongly that their institutions have efficient processes for collateral management, particularly in the area of communication and dispute management.
Part of the problem has been that as collateral needs have gone up, the circulation of existing collateral has gone down, thus contributing to a potential shortfall. Collateral velocity, the ratio of total collateral received compared to the primary sources of collateral, remains in the low 2s as it has for the past few years, down from a rate of three times reuse in 2007.
This lower collateral velocity has occurred for a variety of reasons, says Manmohan Singh, a senior economist at the International Monetary Fund (IMF), including quantitative easing, flat securities lending activity, regulations – especially the leverage ratio – and reduced pledged collateral from hedge funds.
“There’s always a price for which you can get your hands on some good quality collateral. The question is, in a zero rate environment, when you’re hardly making any returns, do you want to spend another 30-60 basis points trying to get high quality liquid assets?” - Manmohan Singh, IMF
One remedy to a potential collateral shortfall could be through cross-asset netting, says Sapient, but tools to perform these functions are still in development and regulators have not completed the final technical standards. “Once available, firms will be able to more easily estimate exposure and the impact of a trade and make cost-effective decisions as to which counterparties to trade and clear through,” an accompanying Sapient whitepaper says.
Yet netting opportunities also differ based on the type of transaction. One lens through which to view the collateral changes for OTC derivatives would be bilateral versus cleared trading support. “In bilateral transactions, there will be more stringent initial margin requirements, though there is also still the possibility for portfolio margining to ease the initial requirements; whereas in cleared, you’re really working with whatever the calculated requirement of the CCP (central counterparty) is,” says Joshua Satten, global head of OTC structured products at Northern Trust Hedge Fund Services. “We will continue to see advances based on the different CCPs evolving product offerings, in terms of what kind of margin relief and cross-margining with other products they may offer over time.”
“We will continue to see advances based on the different CCPs evolving product offerings, in terms of what kind of margin relief and cross-margining with other products they may offer over time.” - Joshua Satten, Northern Trust
Aside from portfolio margining, collateral services such as optimization and transformation will be key to achieving efficiency and cost savings, particularly for larger firms. According to recent research by Deloitte, a firm posting $800 million of average daily collateral in a 0.5% federal fund interest rate environment could save approximately $1 million annually through optimization, while smaller funds that post approximately $100 million could save approximately $116,000. As interest rates rise, savings would increase further.
“Factoring in the build and installation costs, an in-house optimization capability seems more applicable for large asset managers and funds, as they can realize benefits of scale,” says Deloitte in the paper. “While the analysis presented here is primarily driven by potential economic value, collateral optimization can provide other benefits, such as tighter risk management, asset preservation, and liquidity management.”
A transforming experience
In addition to optimization, several providers have begun offering transformation, whereby lower-grade assets can be upgraded to eligible assets via the securities lending and repo markets. “Looking at the competitive landscape, there’s a lot of different players along the line that can provide value and that are trying to provide value,” says Northern Trust’s Satten.
Firms that choose not to use an in-house system and/or go through their dealers for collateral transformation can also outsource these functions, which is where custodians are stepping in to offer collateral management services powered by a combination of proprietary platforms and third-party vendor solutions. This trend is likely to grow, as 66% of custodians surveyed by Sapient said they either intend to, or already offer, some collateral transformation services. The difference in a custodian “being able to offer an overarching suite of middle-office administration and custodial services is that we’re able to act as what I would call the ‘ultimate middleman’ in that we’re able to see and provide support across middleware, across FCMs, across trade repositories, and across regulatory regimes, so as to support the client holistically and globally in a manner in which I’m not sure other entity types are able to do,” says Satten.
Outside of these services, the collateral challenge could also be alleviated by central bank action. “Since regulation and the activities of some central banks has led to a decrease in collateral velocity, they may be forced to come up with schemes like a reverse repo facility that provides collateral in different parts of the world,” says the IMF’s Singh. “They will look at the issue differently, but the fact that you have the reverse repo facility from the Fed and the Reserve Bank of Australia’s contingent liquidity facility tells you that they have acknowledged that, if need be, they will supply collateral or will do something so that the need for collateral or high quality liquid assets will be taken care of.”
These facilities, however, disintermediate what Singh calls the ‘financial plumbing’, in which dealer banks sit in the middle between banks and non-banks in order to move collateral and cash between them. “A reverse repo program allows non-banks such as money market funds to come in and get collateralized funding. If you do this in large size, you will rust the plumbing pipes that go between banks and nonbanks,” he says. If the collateral demand is phased out over a few years, perhaps the system will take care of itself, says Singh, but if the collateral demand comes all at once over the next year, there could be potential risks. “If indeed this is not phased out and there’s an impending need in the next year, you will find a reduction in some markets like OTC derivatives,” he says. “To get a hand on good collateral, it might be too high a price, or the bank balance sheet space may not be there for collateral transformation. There’s always a price for which you can get your hands on some good quality collateral. The question is, in a zero rate environment, when you’re hardly making any returns, do you want to spend another 30-60 basis points trying to get high quality liquid assets? I don’t know. If you’re in a normal yield curve where returns are 6-7% you don’t mind spending 30-60 bps. But when you’re making zero to 200 bps, you may just cut corners and not hedge, or not do derivatives and do hedges via futures [instead].”
Although quantitative easing may have had positive macro-economic effects, its adverse effect is that it takes up balance sheet space at large banks, as non-banks deposit the cash coming from the Federal Reserve.
“The balance sheet at the large banks is not as freely available as it was five or six years ago, and you need that balance sheet space to move that collateral around, to do collateral transformation, etc. And it may not be worth your while to do it for a small client,” says Singh. “If the smaller players don’t get the collateral and don’t use OTC derivatives and go to futures or don’t hedge, you’re not removing risk. The whole idea was to make the system safer. If you go through CCPs, you need collateral. Well, to get collateral you need to go to the same 10-15 banks who are adept at doing collateral transformation. So, in a very ironic way, the same CCPs which you thought were safe houses, in order to get there, you’re making the system more interconnected, because you need the 10-15 banks who do the collateral transformation. So we may be back to square one.”
In March 2014, Sapient Global Markets conducted a Survey to understand how firms are managing and processing collateral. The survey covered a range of firms across the globe, including banks, buy-side firms, CCPs and custodians in North America, the U.K. and the GSA area (Germany, Switzerland and Austria).
The Sapient Global Markets Collateral Management Survey covered a wide range of topics around collateral management, including availability, the impact of regulations and market changes, strategies, dispute management and systems.
The majority of respondents (95%) expect the number of OTC clients with collateral agreements to increase, as well as the number of daily collateral calls. Additionally, over half expect disputes to increase significantly as a result of new participants in the collateral space.
Over one quarter of respondents expect to qualify for the proposed BCBS-IOSCO bilateral margin thresholds by the end of December 2015, while approximately another one third expect to qualify sometime after December 2017.
Given the changes in the collateral market, less than half (45%) of survey participants strongly agree that their institutions have efficient processes for collateral management and are well prepared for future challenges. Almost all respondents believe other institutions are unprepared and need to make significant improvements to their collateral management processes.
The majority of survey participants indicate that collateral management falls within the back office at their institution, but that its core role is a management function (59%) as well as an optimization function (54%). One quarter have plans to move collateral management to their front or middle office.
Two thirds of respondents indicate that collateral management is considered a cost center at their institutions; however, over one third are planning to use collateral management to generate increased revenue.
While less than a quarter of survey respondents indicate they currently use collateral management to generate revenue at their institutions, nearly half of the respondents have processes for the optimization of collateral and another 38% have plans to do so in the future. The same holds true for use of collateral management to reduce funding costs, with nearly half currently doing so and 27 percent planning to follow suit in the future. While nearly half indicate they optimize collateral through re-use, few have plans to do so in the future.
Systems and capabilities
When asked about the core functions covered in their collateral management system, over half of respondents indicated that exposure and margin management, margin and collateral interest calculation, collateral agreements inventory and valuation are fully covered. Functions most often not covered include collateral transformation, collateral forecasting and collateral optimization.
The survey shows that new regulations, such as the Dodd-Frank Act (DFA), EMIR, Basel III or Solvency II, are all seen as main drivers for change in collateral management. Interestingly, all institutions believe that they will not have any significant issues with meeting their collateral management needs, but they do believe that their counterparties may have more serious challenges in this area.
Market participants do not anticipate a ‘collateral crunch’ in eligible assets, but they do expect demand to increase significantly. Efforts by countries to reduce government debt will lead to a decreased supply of high-quality collateral (government bonds). This, in turn, will lead to rising collateral costs, which will impact liquidity.
The survey shows that the collateral space is changing substantially as a result of regulations and cost pressures. There is still some ambiguity regarding certain regulatory requirements across the globe. Firms have implemented tactical solutions to meet regulatory mandates in various jurisdictions.
As the regulations solidify, firms will begin to adapt these tactical efforts and begin implementing strategic solutions in order to remain competitive. Different segregation models, margin requirements, restrictions on re-hypothecations, bifurcated portfolios with both centrally and non-centrally cleared OTC derivatives, limitations on eligible collateral and increases in liquidity ratios all raise the complexity and costs while also limiting historical revenue streams.
The Sapient survey confirms many of the findings of the 2013 survey of collateral management among insurance companies by Insurance Risk magazine, in conjunction with BNY Mellon. Fewer respondents than in the previous year said they currently held sufficient assets of the requisite quality within their investment portfolios to meet collateral margining requirements and other pledges. Only 25% said they ‘comfortably hold’ enough assets, while 19% said they hold ‘enough’ assets. Once the central clearing reforms are implemented only 8% said they would have sufficient assets.
Not surprisingly, the vast majority of respondents (86%) were exploring opportunities to generate additional income from their existing investment portfolio.