The devil of the detail

Costs abound, but isn’t better management of collateral the ideal?

Collateral management in the new, highly-regulated environment requires optimising inventory allocation, often across multiple markets, while managing and stimulating collateral velocity in order to maintain market liquidity through a commitment to rehypothecation.

The only feasible way to achieve all of this is through a technology solution that allows for efficient asset distribution from a pooled collateral portfolio that can also automate the majority of everyday tasks in order to free up teams’ time to focus on disputes and data anomalies.

But first, the regulations. “The main focus [of collateral management] has had to be on regulation with the European supervisory authorities publishing the final draft technical standards on margin requirements for non-centrally cleared over-the-counter (OTC) derivatives on 8 March 2016,” explains Helen Nicol, product director for collateral, clearing and optimisation at Lombard Risk.

“Those institutions that are impacted by the 1 September 2016 deadline have been reviewing the impact of the final draft in order to interpret the rulings and any global variances with the US and Asian regulations.”

“We have also seen interest from organisations looking to move non-OTC business lines onto a central clearing platform where possible,” Nicol adds.

Basel III’s capital rules such as the liquidity coverage ratio and the supplementary coverage ratio are disincentivising heavy balance sheets, causing large broker-dealers to rethink how they use collateral to optimise their way around such capital impacts.

Balance sheet efficiency often involves engaging in upgrade trades in the hunt for balance sheet-friendly, high-quality liquid assets (HQLAs), instead of holding on to hot potatoes such as less liquid equities or dormant cash.

The shift to favouring non-cash over cash collateral is a direct result of Basel III capital requirements and a well established trend that has been gaining momentum in recent years.

The April 2016 International Securities Lending Association (ISLA) market report, which used data from all major industry data providers, cited a 60/40 split, globally, in favour of non-cash.

It is worth noting that ISLA’s report also showed that the transition to non-cash has slowed in the past six months, levelling out at roughly 60 percent. By way of explanation for this, ISLA’s report argued: “As on-loan balances were reduced ahead of the year-end, it would appear that cash collateral loans were returned first.”

“This is perhaps explained by noting that many non-cash collateralised loans (especially those involving HQLAs) are likely to be term liquidity coverage ratio-driven transactions which borrowers would likely prefer to retain.”

The report also highlighted regulatory hurdles still to be overcome, including the US Securities and Exchange Commission’s Rule 15c3-3, which bans the use of equities as collateral for certain beneficial owners, as another likely cause of the plateau.

Despite the slowdown, many industry figures predict the ratio will continue to move in favour of non-cash, in turn pointing to persistently low interest rates as an inevitable driver behind the latest conference mantra that ‘cash is trash’. Other regulatory-driven trends in the collateral management space include a sharp growth in the demand for term trades and collateral upgrade trades, both of which are driven by a need for greater balance sheet efficiency (see box outs one and two) and can be solved by technological means.

Jim Malgieri, head of the collateral management and segregation businesses for BNY Mellon’s markets group, sets out the drawback of short-term loans, stating: “Any funding or lending trade versus cash that has a term of less than 30 days has a 100 percent capital charge. Participants must lock up 100 percent of the value of the trade in HQLAs or leave cash on the books.”

Therefore, in order to remain compliant, a participant must adapt to favour term trades of more than 30 days or exchange equities for HQLAs, usually in the form of government bonds. For borrowers, these trends represent a need to optimise the allocation of diverse collateral buckets, while lenders are more focused on their programme’s collateral eligibility profile, acceptable haircuts and concentration limits.

Breaking down barriers

One crucial adaptation to a collateral management infrastructure is the phasing out of separate silos in favour of a single holistic collateral pool. However, taking such a radical step away from traditional storage methods can be, in a relative sense, more financially draining for top tier entities than their smaller, nimbler counterparts that may not have legacy systems to update.

Ted Allen, vice president of capital markets collateral at FIS, says: “In larger banks, the silos that have existed for many years are much harder to break down. At the same time, big banks are the ones hardest hit by regulation and that’s drawing away a lot of their technology investment budget.”

“The most forward facing firms are looking at adopting a single pooled view of their assets and allocating it globally in the most efficient manner possible.”
“We at FIS often speak to three or four different departments within large banks that all have their own siloed inventory but are not able to mobilise themselves enough to solve their mutual issues in a holistic manner.”
“On the other hand, in the second tier of the industry’s participants, such as regional banks, pension funds and insurance companies, effective collateral pooling is already a reality. That’s looking at derivatives, repo, securities lending, as well as treasury requirements,” Allen adds.

Malgieri reinforces this analysis, stating: “The large broker-dealers have grown up with silos. If you go back five or six years, fixed income and equity desks were separate desks and corporate treasury wasn’t part of the funding scheme. That’s all changed.”

Go go gadget

One major advantage that any vendor will boast about is automation, as both a time- and long-term cost-saving method for both sides of the trade.

“The volume of business that needs to be collateralised is growing and therefore collateral velocity is also increasing, and this turn is driving a trend towards greater automation,” explains Allen. “There is a heavy focus on achieving straight-through processing wherever possible. Firms are moving to an exception-based process, meaning collateral operations teams are only involved in exceptions and resolving disputes—everything else is automated.”

“Using platforms such as [FIS’s] Apex Collateral means that, as long as the data validation checks are passed, the entire margin call process can be hands-free. The volume of margin calls is expected to increase five-fold, but firms aren’t going to hire five times as many staff. In order to adapt to the greater level of volume firms must adapt their processes through automation.”

Build it and they will come

Once an entity sees that its technology infrastructure is no longer fit for purpose, the next question is inevitably whether the new model should be built in-house or come from a vendor. This debate has been raging for longer than anyone can remember, but, for collateral management at least, the end might be in sight.

Thanks to the speed of regulatory requirements in development and the looming fear of yet more to come, the cost of implementation and up keep when every shift of the goalposts potentially signals a massive technological overhaul is simply too much for most to bear.

Allen comments: “There are always firms that want to build in-house because they think they know their own needs best but that is less and less the case. It’s increasingly expensive to build these systems and also the maintenance costs are only going up when you consider all the new regulatory requirements that currently exist or may exist the next few years.”

“Apex has clients who are taking this opportunity to revisit their whole collateral management infrastructure and replacing it with a single platform that covers them across the entire securities financing spectrum. Others are solving the specific problem of optimisation by implementing our optimisation model on top of their separate third-party or in-house solution.”

“For collateral operations, up to 90 percent of firms use a vendor platform,” Allen added.

Malgieri, as head of BNY Mellon’s triparty agent that primarily services lenders, feels these costs acutely. “As a business manager, technology budgets tend not to go down, only up. You must constantly re-invest in your business, especially one like collateral management, which is so technology laden.”

“These are all technology-driven developments in the industry and it’s the triparty agents that have to come up with these solutions. With lender collateral requirements now this complex, efficient technology solutions are the only way it can be done on the scale the market needs,” Malgieri says.

Unlike challenges around pooling collateral, entities big and small are all affected by steep costs to remain compliant with regulations. Nicol offers a blunt summary, stating: “There are no winners in this area. Regulation carries cost implications regardless of whether you have legacy platforms or are a new entrant.”

“Legacy systems will need to be upgraded to incorporate the new parameters or external workarounds reviewed from both a technical and business perspective.”

She adds: “Newer entrants have the benefit of structuring platforms to manage both legacy and regulatory functions as part of the initial purchase and implementation process and can therefore often streamline the requirements but may face a greater challenge in moving from the current, often spreadsheet-based process to a new platform within the timeframes. As a result, we are seeing a growth in interest from the market as they look for viable options.”

There might be few winners here, other than the vendors, as the cynics would say, but that might be missing the point. Afterall, isn’t better management of collateral the ideal? Regulations might be forcing hands, but don’t idle ones do the devil’s work?

Sooner or later, everyone must embrace better collateral management, whatever the cost, or be left behind. SLT

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