This is the first of two articles focusing on how collateral management must evolve to meet the challenges of the new regulatory regime. Whilst we have been collateralising financial market transactions for decades…
…many would argue that collateral management as a discipline (or industry) only began in the mid ‘90s. For those who can remember that far back however, it was very different from today. One look at ISDA’s 1998 Guidelines for Collateral Practitioners demonstrates how far we have come. Simply the didactic nature of the document alone illustrates the general level of prevailing knowledge when it was published. References to, amongst other things, the size of the swap market, less than $30Tn in notional, and the “physical” delivery of collateral serve only to reinforce these differences.
Collateral for OTC derivatives, however, was not the only area of the market that was, by today’s standards, somewhat antiquated. By way of example, a vast majority of users of tri-party collateral management were still manually approving individual securities movements, and the exchange of variation margin for repo transactions was limited to only the very largest investment banks.
It would be wrong to imagine that this absence of robust collateral management processes was a reflection of generally lower levels of counterparty exposure. One needs only to consider the crises caused by the collapse of Baring Securities and Drexel, Burnham & Lambert along and the (swaps related) bankruptcy of the State of Orange County, all in the 90s, to conclude that collateral management as an industry was, in this era, simply ‘immature’.
The New Millennium
Lets fast forward only a handful of years to the mid 2000s, and we see a very different picture. Amongst a raft of changes, three standout as being pivotal to the developments made.
Firstly, the dotcom bubble had burst sending the markets into a tailspin with the subsequent default of some exceptionally large US corporations. (Most infamous amongst these were Enron and Worldcom.) Added to this had been a series of global macro economic shocks; the 1998 Asia crisis and, in the same year, the Russian financial crisis. These had been followed in quick succession by the Argentinian debt default of 2001. Not to forget the collapse of LTCM in 1998 – a poster child of the risk management industry today.
It is perhaps unsurprising given the above that virtually all major market participants were getting serious about collateral management at this time. A good deal of the modern narrative around the role of collateral and indeed the risks of a collateral programme were born or materially reinforced during these few turbulent years.
The second major change was the buyside beginning to use OTC derivatives transactions with a vengeance. This shift alone radically altered the collateral landscape. Up until they began to trade swaps, most buyside institutions were not actively managing collateral: a majority of stock loan programmes were run by Global Custodians, collateral for Futures & Options transactions was, in a vast majority of instances, cash and variation margin on repo transactions was infrequently exchanged. The use of these instruments therefore was the trigger for non-tier 1 organisations to begin managing collateral themselves. OTC derivatives collateral management outsource service providers were rapidly created to meet this nascent demand amongst the buyside.
The third shift was a significant increase in sophistication and automation, principally, within investment banks. Under a range of banners, the optimisation of collateral had become an industry in its own right. Collateral Optimisation Groups were created to manage larger pools of collateral over multiple instruments and asset classes. This demand for efficiency had prompted tri-party service providers to further automate the solutions they offered to their investment bank clients. In addition to these advancements in automation and optimisation, market participants were pushing the boundaries on what was acceptable collateral, as balance sheets became ‘cluttered’ with esoteric and illiquid assets. As was generally recognised too late, whilst risk managers had not lost sight of the primary role of collateral, for most other groups in the bank it had simply become the primary ‘building block’ by which balance sheets were expanded!
Post-crisis Collateral Management
It will be no surprise that the third, and current, age of collateral began in 2008 with the Global Financial Crisis. Whilst collateral did not cause the crisis (far from it) it definitely played its role in both limiting its impact for some institutions as well as being the primary cause of the demise of others. With regard to collateral management itself, many of the warnings around managing a programme which had been entirely conceptual up to this point became shockingly real. Chief amongst these was the liquidity risk that the creation of a collateral management programme creates.
The regulators response post 2008 is what really characterises the current thinking around collateral management, and creates the challenges with which the market is currently grappling. These may be broken down into three main categories:
- Increased usage – The migration to Central Clearing for multiple instruments, mandatory VM for all OTC derivative transactions, maximum thresholds along with initial margin for non-cleared transactions will increase both the values of margin in circulation and the frequency of calls.
- Increased complexity – Whether it be segregation models, dynamic haircuts, risk sensitivity driven initial margin calculations or a host of other changes the management of collateral is becoming far more complex
- Increased cost / opportunity – It is hard to argue that the impact of points one and two above will not lead to an increase in costs. This cost increase however will also allow certain organisations to prosper where they adopt a strategy that is proven to be effective in the face of this rapidly changing landscape.
As it has been widely acknowledged elsewhere, collateral, along with capital and reporting, are the cornerstones of the new regime. If we are to believe the regulators, this trio of regulatory strategies will indeed protect the capital markets from a repeat of the disaster that began unfolding in 2008.
The future of collateral management
For every action there is of course a reaction. Whilst surely an unintended consequence, there is a risk that the regulators themselves have created an environment where the very institutions that they were looking to protect are those that have been placed in harm’s way.
To expand further, under today’s regime, where institutions are able and prepared to spend significant amounts of money on new or expanded systems, they can achieve two highly desirable outcomes. They are far better able to leverage the new regulations through the implementation of additional risk mitigation policies such as trading with a broader range of counterparties, appointing multiple clearing brokers, implementing complex collateral segregation models and enhanced reporting (the benchmark of any collateral management programme). In addition, these same institutions are also able to further lower risk through increased automation across the entire margin they exchange and manage.
By contrast, those institutions that are unprepared or unable to spend significantly on sophisticated systems are far less able to implement those risk reducing policies described above, or benefit from the automation that a migration to a modern platform must bring. This leaves them far more exposed to the operational and liquidity risks that were the downfall of many institutions in the last financial crisis.
This conclusion is easy to reach. It is a direct function of the inverse correlation between risk and cost that has been created by the new regulations. It is of the uppermost importance that this relationship is severed. The way to achieve this is straightforward: innovative solutions are required that allow the non-tier 1 institutions (the vast majority!) to manage collateral in a manner consistent with their tier 1 counterparties and clearing brokers. This is not limited to just OTC derivatives however. It is also true of all cleared transactions, stock loan and repo. In actual fact, this is where the non-tier 1 institutions have an advantage. They are more easily able to achieve an enterprise wide model, where all collateral is measured and managed in a central location, than the tier 1 institutions with whom they trade whose attempts at enterprise wide solutions are blighted by the legacy systems in which they have invested so heavily in the past.
In summary, where we consider the future of collateral management it is not difficult to determine what the near / medium term picture looks like. Rather, the challenge is how do a majority of market participants arrive at this ‘destination’ in a manner consistent with their broader institutional strategy and in line with the regulators demands. As is so often the case, it seems that innovation is the answer.