Buy-side firms are lagging behind the sell-side when it comes to creating centralised collateral management desks, but this is beginning to change, according to a report from consultancy Finadium.
In the second part of Finadium's annual asset manager survey, which polled 39 executives at asset management firms, the study found that 36% of those trading OTC derivatives have already begun the formal process of creating a central collateral funding desk. The survey also found that 29% commingle collateral by allowing one fund or asset pool to borrow from another, but this still leaves silos, where each pool manages its own collateral obligations.
On the other hand a central collateral desk break down these silos, as it “organises all supply and demand requests, sorts out all internal options first, then turns to outside parties to satisfy the remaining requirements,” said the report.
Finadium finds that securities lending desks are the most popular original source of a central collateral team for buy-side firms, which sometimes morphs into collateral sourcing while other times the team provides core expertise that rolls into another desk, usually in treasury. According to the most popular answer at a Finadium conference in New York in June (composed of both buy- and sell-side participants), these central collateral desks should be managed by a firm’s treasury department, rather than repo, securities lending or another division.
Finadium’s report also finds that insurance firms are less likely than fund managers to outsource collateral management, even if the insurance company has outsourced back-office clearing and settlement functions.
In Finadium’s view, collateral management should be managed internally if it’s a core competency, though this measure can be difficult to determine. “Our observation is that if collateral management, both receiving and delivering, occupies at least one individual for an entire working day, then the activity should be considered a core competency,” says the report. “At that point collateral could conceivably become a money-making activity due to the volume of inflows and outflows. Otherwise it is worth looking at outsourcing both the operations and technology, or licensing a cloud-based technology solution for an internal employee to run.”
A recent study by technology provider 4sight (which offers a collateral management platform) and Rule Financial agrees that the decision to outsource or manage collateral internally differs case-by-case.
“There is no single solution which prevails as the best approach to collateral management for all firms. For example, if you are long money, short resources, have simple schedules, and no desire to optimise, the best answer may be to outsource it,” the study said.
“However, certain aspects of the process will always need to be checked internally. The due diligence process of any outsourcing must be rigorous and detailed to ensure that the service provider manages the client’s collateral in line with its risk guidelines and avoids any misunderstanding.”
According to 4sight and Rule, outsourced collateral management costs rise as trading volumes increase, and as time goes on, in-house expertise is unlikely to have kept pace with industry developments, making it harder to move away from the service provider.
“The optimum solution is almost always a combination of business process outsourcing and internal management, but the balance of the two varies from firm to firm,” says the whitepaper.
In terms of the technology firms use, every large insurance company and fund manager that Finadium spoke to for its report used internal technology to support an internal collateral management process. Three of these firms only use Excel, which Finadium suggested are acceptable for firms with just one or two trades a month. Two other firms in the report were preparing an RFP process for a technology platform, though, and while “custodial technology may be considered an option for these firms, neither was considering outsourcing all operations and technology to their custodians,” the study said.
A variety of collateral management systems such as 4sight’s have made their way into the market, but none appear to be a “market leader yet in this space, and managers that had recently reviewed different vendors reported little difference in functionalities,” added Finadium.