THE COLLATERAL CONUNDRUM.
Simon Lillystone, consultant at SmartStream explores the different hurdles to overcome and the options on offer.
Has the delay in EMIR to next year pushed collateral management down the agenda?
Not at all. The changes required for European Market Infrastructure Regulation (EMIR), International Organisation of Securities Commissions (IOSCO), Basel Committee on Banking Supervision (BCBS), et al by collateralising firms are incredibly substantial, and firms are simply using the extra time to introduce new functions, processes, and solutions to deal with the complex requirements in a controlled, rather than uncontrolled manner.
Estimates for the shortage of high quality collateral vary. What do you envisage?
It’s not the focus of SmartStream to be guessing future ratios and liquidities in certain instruments or assets types. Instead, SmartStream is concentrating on developing the optimisation capabilities of its collateral and margin management solution, TLM Collateral, to enable firms to make the most prudent choices of assets they can from their available inventory, especially within the context of their primary business activities (eg. securities versus cash, which obviously differs significantly between buyside and sellside). At the same time, it’s true to say that the new requirements for initial as well as variation margin, and gross instead of net exposure will severely test firms’ ability to manage the impact on capital and available assets.
What do you see as the greatest challenges given the regulatory requirements in this area?
The ramification of the changes proposed by the various regulatory bodies are significant in every way – even just on a functional level – group thresholds, currency mismatch haircuts, initial and variation margin, gross rather than net, currency-specific margining, and so on. However, firms also need to have systems that can comfortably deal not only with the jurisdiction-specific aspects (eg. the differences between the Eurozone and the US being obvious ones), but also the timing aspects. For example, some regulations will come into force before others, and will apply to certain categories of institutions before others. Furthermore, these firms will still need to deal with the margining of their legacy OTC businesses, as well as their repo and securities lending activities. Therefore the greatest challenges are all about having multi-dimensional, flexible collateral and margin management solutions that can handle old-world as well as new-world business – and the impact on volumes and resources this brings.
How do you see financial service firms restructuring the way they allocate collateral?
As previously mentioned, the need to provide currency-specific initial as well as variation margin, combined with the restrictive opportunities for collateral re-use (the so called act of rehypothecation) and the denial of or meagre returns on interest on cash positions are going to cause all firms to focus on ‘optimisation’ – which will mean different things to different firms. For many, where volumes are moderate, and the business linear – this will probably amount to nothing more complex than preference management over the available inventory. For others, and some have already introduced this, they’ll be after fully-algorithmic solutions, such as TLM Collateral, that can simultaneously satisfy multiple margin calls with multiple available, eligible positions, utilising multiple optimisation rules.
How will it differ from the past?
If we’re talking about collateral (allocation), then in simple terms, in the past, collateralising firms would overwhelmingly use cash, since it was the easiest to handle, and the interest rates offered to one another were often very beneficial. Some even used term deposit structures since collateral might stay on account with one party for a considerable time without intermission. They would also structure their CSAs (credit support annexes) to include thresholds and other calculation parameters that would, in effect, limit the flow of collateral, and create a non-linear relationship between exposure and mitigation (which many would say was entirely legitimate, since the purpose of collateralisation is to mitigate credit risk – and no two firms are equal in this regard).
However, in the newly (over)regulated, and centrally cleared worlds, such things are made minor. Thresholds are largely out; currency-specific and gross margining are firmly in, and firms will need to dig deep into their available inventories to come up with the collateral to meet the new requirements, that would have been avoided in the past. Finally, they’ll also need to do this across the bifurcated derivatives business – simultaneously managing cleared and non-cleared margin requirements.
Will they continue to use a preference based system or opt for collateral optimisation?
SmartStream’s primary focus is to satisfy the needs of its customers and the markets in general. Our collateral management solution provides extensive and flexible integrated coverage for both simple optimisation (preference and priority-based functions) and complex optimisation (algorithmic, multi-threaded, calculation and allocation engines). To a large extent each firm, when they start to consider these options seriously will need to judge the cost-benefit analysis – and for many, at the moment, the preference-based route is still the most pragmatic one. However, there are many firms that are, or wish to be, heavily-inventory focused, and so the optimisation route is going to be the one for them.
If so, can you provide more detail on the inner workings, benefits and drawbacks of optimisation?
Since the goal of asset optimisation is to use one’s inventory in the best way possible (not just for the purposes of collateral management, but also for trading, liquidity, and capital management purposes), then it should be easily possible for firms to identify the benefits in their own context. The challenges (and perhaps drawbacks) are:
- In the shape of re-designing the organisational structure. This means having a dedicated desk or function, whose primary focus is to use optimisation as a means of enabling all parts of the organisation to benefit from targeted allocation of available assets (inventory). In this regard, I could well see the traditional collateral management unit being the ‘margin managers’ – ensuring that all requirements for margin with counterparties are negotiated and agreed successfully. There is also the collateral manager who uses the optimisation engine to satisfy all the negotiated margins automatically, in the most optimal way (in contrast to the past where margin calls would be handled sequentially, in a single threaded, resource-intensive way).
- That not only does the inventory change every day, but also the markets, and so margin requirements change. In other words, yesterday’s optimised inventory is not today’s, and so firms will regularly need to rebalance the inventory. This means looking at the existing allocations and comparing them with the current portfolio, market conditions, internal requirements and potentially generating multiple back-to-back substitutions. For example, recalling a now valuable asset, for one that is less valuable to the firm. TLM Collateral Optimisation can perform this rebalancing – but readers have to be aware that the act of re-balancing can not only create a lot of churn within the portfolio, but also generate additional costs to service the substitutions and introduce heightened settlement risks. The bottom line for firms is to spend sufficient time to develop an understanding of the net benefits and consider all the ramifications of entering into an optimisation programme.
What would the cost savings be?
There are two aspects to cost savings, if we are particularly focusing on the optimisation strategy. The first, which is maybe less tangible, is that the optimisation engine is trying to perform a multi-dimensional, multi-threaded method of allocating mitigants to obligations. Therefore one could say that each firm needs to decide what the criteria are for developing such a capability (and enshrining those parameters, metrics and rules within the solution), and then determining the cost-benefit in their own terms. The second, which is perhaps more tangible, or at least can be more easily quantified, is to compare the result from one day to the next of performing the rebalancing function and then seeing the delta. SmartStream has assisted clients with this sort of exercise on a number of occasions, and though one needs to see numbers in the context of the organisation concerned, it can point to a mid-sized European Bank that identified potential annual savings of some E8-10m. Furthermore, it observed that by performing the top ten recommended substitutions alone would deliver over 80% of the annualised predicted savings.
All this makes me recall my distant past in collateral management, when I marvelled at the audaciousness of the global collateral manager of a Swiss investment bank who rightly claimed, through his prudent selection and allocation of assets, that his department would be a profit, not cost centre. From then on few have explored this aspect of collateral management, where the value of the pools of collateral can reach many billions of Euros – and therefore the potential savings incredibly significant.
I suppose the good news is that new regulations, and the squeeze on liquidity that comes with it, has prompted optimisation to become critical to business continuity and, ultimately, success. n
Simon Lillystone has been working in banking and technology for almost 25 years, and the last 18 of these have been focused on collateral and margin management: first with J.P. Morgan, and then Deutsche Bank, before positions with SunGard, Omgeo, IBM, and now SmartStream. Prior to SunGard, Simon designed and created one of the first vendor solutions for collateral management.