The Future of Collateral Management
This article makes up the second of two articles focusing on how collateral management must evolve to meet the challenges of the new regulatory regime. To read the first part of this series, click here.
The conclusion to the first article in this series was simply that, specific to a majority of non-tier 1 organisations and in the absence of innovation, the Regulators’ response to the Global Financial Crisis is likely to introduce new risks. One could comment that, on balance, these risks are potentially greater than those that these institutions faced during the crisis itself.
The rationale is hard to contest where the forecasted increase in the use of collateral introduces liquidity, correlation and operational risks to a group of market participants that were not threatened with insolvency during the crisis. Critical to this argument is that, without further innovation, many market participants would struggle to manage these new risks in a manner consistent with their tier 1 brethren who have, often over many years, invested in systems designed to automate and facilitate the exchange of margin.
All this said, innovation itself is simply a catch-all term often used to bridge the gap between reality and some hoped for future. Combine this with trendy neologisms like ‘FinTech’ and create a Silicon Roundabout, and Hey Presto! A panacea for all market ‘ills’ is born.
If only it were that simple. Innovation itself comes in many different forms…not all of them ultimately desirable or successful. To better understand the demands being made of innovation we should look first at the regulations themselves.
To simplify matters, it is easier to consider the regulatory universe in two halves. The cleared world and the non-cleared world. It also makes sense to consider those regulations, which impact the non-dealer/MSP community directly, and those that will indirectly prompt changes in behavior. Elsewhere, this has been described in the context of exemption and immunity i.e. simply because an institution is exempt from a regulation does not mean they are immune from it’s impact. As we look further into the future, these second order effects become increasingly important.
For the years following the G20 commitments in Pittsburgh, it was widely believed that the introduction of mandatory clearing would simplify matters for a majority of market participants. The received wisdom being simply that the clearing of OTC contracts would be analogous to clearing Futures and Options and hence would be broadly problem free. More recently, this perspective has changed significantly for three primary reasons.
Firstly, in contrast to Futures and Options, there are multiple different account structure options being offered by clearing houses and clearing brokers for OTC derivatives. Whilst regulations demand that CCPs offer individually segregated accounts, most CCPs are aiming to go one step further by allowing the buyside – historically clients of clearing members – direct access to the clearinghouse itself. Many of these account structures materially alter the collateral process flows and the level of protection in the event of a member default. Whilst the benefits of these new account structures are clear, especially from a risk management standpoint, the complexity they bring to the collateral management process is manifold.
In addition to the complexity around account structures, further operational challenges are being driven by the clearing brokers’ efforts to address some of the capital and credit impacts to which they are increasingly subject as a result of Basel III. To avoid funding the retention of liquid assets, (under the Liquidity Coverage Ratio regime) clients are being encouraged to use securities wherever possible for initial margin and recall excess cash rather than leave ‘buffers’ as was historically the case. In one fell swoop, from an Operations standpoint, the challenge of managing cleared margin is similar to that in the non-cleared space!
The final consideration where cleared margin is concerned is that of liquidity risk. As values of initial margin for cleared activity rapidly grow, the risks of not meeting a margin call increases. The current narrative in the market around this is that collateral management is becoming a front office discipline. It’s hard over the medium term to argue against this. The front office is looking for sophisticated tools to forecast initial margin requirements. This is both a complex task and needs to be integrated with the broader collateral management process.
The above illustrates very well the points made above regarding increased risks under the new regime. That is to say, those institutions that are more readily able to manage their collateral will be able to adopt the more tailored account structures at CCPs (and lower risk), and also manage the collateral they may hold with clearing brokers more closely (and avoid costs). In addition, the impact of LCR is perhaps the best example of the ‘exempt but not immune’ model.
As mentioned elsewhere, it is not just the cleared world that is changing. Major changes are also occurring in the non-cleared world.
The mandatory exchange of variation margin for all market participants is now a key element of the new regulations. The addition of mandatory maximum thresholds serves to ensure there are no ‘loopholes’ in the rules. Many institutions today margin all their OTC derivative activity. This said, there are still a number who don’t. The net impact of this is that the regulatory requirement (from March 2017) to exchange margin on a daily basis with enforced thresholds represents a challenge to a number of market participants of all sizes and levels of sophistication.
In addition to the daily exchange of variation margin, for a small number of institutions there will also be initial margin to consider. Current forecasts suggest that by 2020 there will be 59 banks which breach the threshold for the exchange of initial margin with an unknown number of buyside firms. The unknown here is just quite how much activity will be supported by vanilla (and hence cleared) OTC derivative transactions – and where there is demand for tailoring, how many institutions will be prepared to pay the increased costs of non-cleared transactions? In any event, the exchange of IM for non-cleared transactions is a clear challenge for those institutions captured by the rules.
To understand the nature of the challenge it is helpful to consider the difference between variation margin and initial margin: variation margin is simply the mark-to-market difference on a portfolio. Initial margin is the sum of money that could conceivably be lost over a defined period, post a default. Critically it is a forecast rather than a function of currently observable market values. The calculation of this forecast and the agreement with a counterparty (where their forecast may differ) is a material challenge for those market participants captured by these regulations.
Again, the above illustrates the points previously made. The non-cleared margining rules will again add complexity and operational burden. As has been highlighted elsewhere, the increase in the number of movements alone represents a material increase in operational risk and cost.
In summary, cleared or non-cleared, exempt or immune, the collateral landscape will change dramatically over the course of the next few months and years. Rather than being an expansion of historical challenges, the novelty of the new regulations is fundamentally changing the ‘problem statement’ as it relates to collateral management.
Innovation in Collateral Management
In reference to the first half of this whitepaper, and in very high level terms, robust, flexible, functionally rich collateral solutions need to be brought to the masses rather than being the reserve of only the largest or most sophisticated market participants. Wherever possible, solutions need to cover all instruments (as bifurcation creates inefficiencies and increases both risk and cost) and priced in a way (and at a level), which reflects the scale of the challenge for those impacted institutions. Put differently, whilst the costs of inefficiency is increasing, solutions still need to be made available at a fee level consistent with the cost appetites of the target companies.
Taking into account all of the above, whilst it is impossible to say definitively what the future of collateral management looks like, the following advancements seem highly likely:
- The most effective solutions will be deployed via the cloud: As the adoption of cloud solutions becomes far more commonplace across all areas of finance, collateral management is very well positioned to be part of that wave. SaaS solutions work most effectively where many people or institutions follow, broadly speaking, the same processes. Collateral management fits this requirement. In common with other SaaS solutions, cloud based collateral management platforms should be functionally rich, far more affordable than on-premise or outsourced equivalents, easier to develop and maintain – with far more connectivity than most market participants would be able to achieve on a standalone basis.
- Multi-instrument platforms will prevail: Where cost, liquidity and complexity is a factor, it is critical that an institution can view its collateral requirements across all instruments; cleared and non-cleared. This will become increasingly obvious where the values of cleared margin increase and the costs of inefficient collateral practices between clearing members/FCMs and their clients grow significantly.
- Within very defined parameters collateral will become a front office discipline: Given the higher values of collateral in circulation, the requirement for pre-trade analytics and collateral optimization is becoming a clear requirement for those organisations with significant, directional portfolios of swaps. A number of tech companies are springing up to address this need already.
- The importance of tri-party structures will increase: Whilst somewhat time consuming to implement, the use of tri-party (in the book entry allocation sense of the term) will grow. In the near to medium term this will be correlated to the growth in the use of Initial Margin.
- Competitive advantage delivered to those institutions that get it right: This competitive advantage will be felt in two ways. In the near to medium term it will manifest itself in terms of increased P&L (or fund performance). More importantly however, it will be seen most acutely during the next financial crisis. Certain institutions with efficient practices and processes will be able to navigate distressed markets with ease, whilst other firms will struggle both from an operations perspective but also in terms of risk management through liquidity etc.
It goes without saying that we will inevitably use tomorrow’s tools to solve tomorrow’s problems, and that there is always risk when it comes to gazing into the crystal ball and looking into the future.
Within financial markets, there is often an expectation that innovation will bridge the gap between an undesirable future state and one that is more palatable. Very often this expectation is NOT misplaced in an industry that has proven time and again that it can evolve as market practices, opportunities and regulations demand.
Specific to collateral management and based on what we see in the market today, a blend of new technology, new providers and a combination of different solutions (some existing and some new) represents the optimal approach for many market participants to negotiate the new challenges they face.
None of the above will happen overnight. Real innovation, the sort that disrupts and transforms is often an amalgam of multiple strands or initiatives and not always born, directly at least, of consumer demand. To paraphrase Einstein, it needs someone with inspiration and very often an army of people to provide the perspiration!