‘Once upon a time, in a regulatory landscape far, far away’ may sound like an opening to a fairy tale, but the reality is that the regulatory landscape is now beyond recognition for even the most grizzled and battle-hardened of collateral managers. The Dodd-Frank Act, Basel III, the European Market Infrastructure Regulation and other global equivalents have left the collateral pool shuddering at the concept of an unprecedented demand for collateral comprised of high-grade assets and an increase in haircut provisions. While it is noted that increased collateral requirements in the market means greater safeguards against default, conversely, the ever-increasing demand for high-grade collateral also has an inherent destabilising market factor.
Buy-side institutions have limited access to large inventories of high-grade collateral, which gives rise to the phenomenon known as ‘collateral scarcity’. The current economic climate, coupled with stressed market conditions, only exasperates this notion. In the collateral world, this means higher margin call volumes, an increase in the number of margin disputes and adverse operational capacity implications.
Since the 2008 financial crisis, regulators have made huge strides towards stabilising the global financial system via regulatory reform. This has essentially created a tornado of regulations, consuming all forms of high-grade collateral in the market, leaving a trail of fewer and fewer smaller institutions and buy-side firms in its wake as a direct result of the new and all-encompassing collateral requirements. Additionally, liquidity ratios and capital requirements are coming under increasing pressure from regulators—all of which are fuelling the whirlwind ultimately creating a perfect storm.
Global financial institutions are striving to manage risks and collateral requirements as efficiently and intelligently as possible. Now more than ever, there is a distinct need to reduce the fragmentation of global collateral pools. As more and more firms are finding it too expensive to manage collateral on a cross-border basis, secured financing is now seen as one of the most effective techniques in meeting the new-found demand and squeeze on collateral pools.
Secured financing is a critical contributor to the efficient functioning of global capital markets. The securities financing business is gathering momentum and repo agreements have been established as the flagship securitised finance product, with more and more firms becoming savvy to its importance to the entire industry. Repos are the most widely and commonly used securities financing transactions and are fast becoming the foundation of capital market liquidity.
For those of us who remember the ‘good old days’, repo agreements, in conjunction with collateral management in general, were somewhat viewed as a back-office function, domiciled within operations—an afterthought in many ways. However, the lowly repo transaction is now viewed as an integral component of the banking industry, aiding liquidity and effective inventory management. Repo transactions are fundamental to the provision of an untapped global inventory of high-grade collateral to smaller institutions and buy-side clients, while simultaneously providing sell-side institutions with further profitable business and revenue streams.
With this in mind, a significant byproduct of regulatory reform is concentrated around the repo market and the anticipation of an unprecedented spike in repo trading volumes. However, gone is the era when efficient and effective credit risk management of repos could take place with the use of a notepad and an abacus. The increasing market demand for these transactions brings with it additional complexity and operational challenges in supporting them. As a result, financial technology companies and their solutions have moved to the forefront of a previously antiquated collateral management space.
Improving efficiency in repo collateral management is, as always, proving a challenging task. One of the biggest obstacles envisaged by institutions pertains to IT complexity in the form of product silos, multiple systems and data touch points, and a lack of technical integration. Significant initiatives in this space include the move towards single-platform, cross-product margin systems and electronic messaging. Many of the repo processes in place today have not been historically dynamic in approach. Process automation, calculation and pricing flexibility are areas of concern, given the anticipation of greatly stressed repo trading volumes on the horizon.
Control should be at the forefront of any efficient repo collateral management process and ultimately be automatically embedded into technology workflows. The support and validation of collateral eligibilities, concentration limits and sufficiency checks are often manual and exposed to a great deal of operational risk in the repo space. Therefore, the introduction of any margin system should provide a safeguard to operational risk by preventing the booking of ineligible collateral, and, where possible, assist in the identification of the most optimal collateral postings. Repo margining would benefit greatly from dynamic exposure calculation and real-time integration to upstream and downstream data sources. There is now a real need for automated statements and reconciliations, which would ultimately reduce the need for external solution provisions by third parties.
Firms need to be gifted the technological flexibility to support the wide variety of margin methodologies employed globally without manual intervention, and the ability to re-run calculations on an ‘any-time’ basis, especially in market stress scenarios. The growing need to forecast exposures and simulate ‘what-if’ scenarios is key to enabling and maximising an efficient management of collateral inventory. This can further be achieved by breaking down product silos—providing a holistic, cross-product view of risk to optimise firm-wide collateral inventories. Competitive advantages such as these are not only proving to be critical to the success of any institution, but to the financial industry as a whole.
In conclusion, since the collapse of Lehman Brothers, the use of repo agreements has experienced a cultural revolution. Long gone are the market perceptions that repo collateral management is the poor cousin of its counterpart. No longer is repo, or collateral management in general, lurking in the shadows of the more en-vogue front-office machine.
Under the ever-changing regulatory landscape, post-trade operations are becoming key drivers of profit. Access to high-quality collateral positions via repo transactions and the competitive edge gained from technological efficiencies are vital to market liquidity and the elimination or easing of the collateral scarcity phenomenon. Is the historically undesirable repo of the collateral and trading world now at the very forefront of market stabilisation? From its humble beginnings, repo could finally now be given the opportunity to shine, and be seen as the platform for effective collateral and inventory management.