For an investment manager with more than $16 billion assets under management (AUM), the costs of an outsourced collateral management exceed those of an in-house solution (see figure 1), according to consultancy and services provider Sapient. In its white paper ‘Collateral management: when does it make sense to outsource?’ issued in July, it modelled the expenses that the choice of buying has against that of building.
However, cost is not the only factor involved in the decision to outsource; the technical challenge of moving, tracking and exchanging collateral is such that outsourcing providers are seeing a boom in interest.
Neil Wright at Sapient Global Markets says, “The asset servicers and custodians are seeing a lot of demand for collateral management services. Given the evolving rules the buy-side are looking to see what they can avail themselves of.”
Collateral management is a complex process which can impact risk and use up resources. The 2009 commitment by G20 countries to centrally clear over-the-counter (OTC) derivatives, put into force under the Dodd-Frank Act in the US, the European Market Infrastructure Regulation (EMIR) and numerous other national regulations, requires the use of collateral to support derivatives trading.
It must be posted by investment managers and other market participants as a margin with central counterparties (CCP) or direct counterparties to cover the risks and costs associated with derivatives trading. If one counterparty goes bust the CCP can use its collateral to cover the costs of selling on its positions, so the impact on other counterparties is minimised.
The collateral used for initial margin, posted with a CCP or counterparty to cover the value of an OTC swap transaction, must typically be of high quality currency or high quality investment-grade fixed income assets. Both are typically liquid and relatively low in volatility. Variation margin, which has to be posted intraday to cover price movements for interest rate swaps or credit default swaps must be in cash.
While the advantage of ‘covering bets’ with margin is to reduce systemic risk, it also increases costs, particularly for buy-side firms. Alternative asset managers may use derivatives as part of alpha-generating strategies but long-only firms typically only hedge with swaps and see limited return from the expense of margining. The processes and technology to manage collateral add to that.
“Employing a tri-party agent removes a lot of the operational risk of managing collateral bi-laterally,” says Jeannine Lehman, head of EMEA global collateral management and segregation at custodian bank BNY Mellon. “Bilateral collateral programmes between buy-side back offices and dealers may still exist.”
When trading was largely bilateral and uncleared managing collateral arrangements did not constitute a significant cost they were not the responsibility of traders. Following the regulatory mandate has changed that says Thijs Aaten, managing director for treasury and trading at APG Asset Management.
“Collateral used to be a back office activity, but now the back office should just focus on the settlement of the trade,” he says. “The call on which bond to send to which counterparty is a commercial decision that should now be taken by traders. Among smaller firms there is still a lot of effort that has to be made in that respect.”
This has not constituted a wholesale shift of responsibility to the front office for larger decisions, such as whether or not to outsource, but rather a blurring of the lines as the impact now reaches from front- to back-office.
Miles Courage, chief operating officer at JPS Alternatives Group, a credit-focussed hedge fund, says, “Derivative operations used to operate in a relatively self-contained manner. Increasingly, front office, operations and counterparties are inextricably linked with many interdependencies. Collateral management and clearing activity, for example, are not conversations for any one of those in isolation, they all have to be included.”
Buy-side firms have a varied understanding of the new regulations depending upon their sophistication, size, trading strategies and mix of instruments. Consequently firms can be found at all stages of awareness around their clearing obligations, collateral needs and options for managing collateral.
Jörn Tobias, managing director of product management for asset management EMEA at custodian State Street says, “In terms of readiness for outsourcing, some firms have been determined to outsource from the start; others are really starting off at an exploratory stage and going through an request for information (RFI) process to decide between buy-vs-build.”
To have an informed conversation about outsourcing options will require all internal stakeholders to be brought in and a clear understanding of what outsourcing can offer.
Evaluating the options
Outsourcing offers a variable cost base rather than a fixed cost base which is one driver. As regulation continues to evolve with rules now targeting the uncleared trades, and discussion around existing rules continues, the potential for further cost hikes increases.
Tobias says, “Very often outsourcing to us is perceived to be more flexible, allowing change over time so [clients] can adapt their operating models to meet the regulatory requirements.”
It also takes some of the operational risk out of developing a solution in-house with the advantage that an established solution will not only be market proven but can be delivered far more quickly than building a platform.
Pierre Lebel, global head of client collateral management at Societe Generale says, “Establishing in-house technology and operations for collateral will take you between a year and a year and a half. Outsourcing will take a month to hire consultants and issue an RFP, a month to analyse the RFP responses and three or four months to get set up with your collateral management outsourcing provider. So Five to six months or 18 months – it’s your choice.”
Furthermore there are operational advantages, as using the expertise of a large sell-side firm that has a dedicated team and technologies monitoring client operations can provide some degree of safety.
Lehman says, “There are certain provisions when using a collateral agent designed to cover a collateral shortfall. We mark to market daily, we use several sources of pricing, we monitor intraday credit and collateral movements so there are many operational risk measures that help us to minimise the risk of a shortfall.”
Clarity and certainty
There should also be a distinction made between collateral transformation services and outsourcing says Ido de Geus, head of Treasury & Client Portfolio management at PGGM Investments.
“Where you have a tri-party arrangement an agent can manage and oversee your collateral but they are not really intended to give you balance sheet to provide collateral transformation services. They offer it but I don’t believe it is workable except maybe for small clients – we manage over Ä180 billion in assets with big cash portfolios in money markets and I don’t see a custodian covering that for collateral transformation purposes.”
However asset managers should be wary of thinking the whole problem has been lifted from their shoulders warns Aaten.
“Outsourcing solves the technical difficulties, if you want to process collateral yourself you need a lot of repo arrangements and technology in place, so I see that some buy-side firms are far better off to buy this rather than make it,” he says. “But outsourcing doesn’t imply that you do not have to understand what the economics are.”