While regulation increases collateral needs, particularly as the derivatives market moves toward central clearing, market participants are cobbling together fragmented systems, manual processes, and siloed approaches to ensure compliance, creating significant inefficiencies, says Sapient Global Markets in a recent whitepaper.
A preceding Sapient survey found that only 45% of market participants felt strongly that their institutions have efficient processes for collateral management, particularly in the area of communication and dispute management.
As collateral needs rise, which will likely increase the number of disputes, increased straight-through-processing rates through automation will be key, says Sapient. To improve the emerging complex collateral processes, the firm has also developed—through collaborative conversations with custodians, institutional investors, futures commission merchants (FCMs) and swap execution facility operators—the Clearing Connectivity Standard (CCS), an International Swaps and Derivatives Association (ISDA)-supported messaging standard for margin statements for cleared derivatives.
Part of the problem, though, has been that as collateral needs have gone up, the circulation of existing collateral has gone down, thus contributing to a potential shortfall. Collateral velocity, the ratio of total collateral received compared to the primary sources of collateral (thereby measuring how many times collateral is reused in the system), remains in the low 2s as it has for the past few years, down from 2007’s rate of three times reuse. This lower collateral velocity has occurred for a variety of reasons, says Manmohan Singh, a senior economist at the International Monetary Fund (IMF), including quantitative easing, flat securities lending activity, regulations—especially the leverage ratio, and reduced pledged collateral from hedge funds.
One remedy to a potential collateral shortfall could be through cross-asset netting, says Sapient, but tools to perform these functions are still in development and regulators have completed the final technical standards. "Once available, firms will be able to more easily estimate exposure and the impact of a trade and make cost-effective decisions as to which counterparties to trade and clear through," the whitepaper says.
Yet netting opportunities also differ based on the type of transaction. One lens through which to view the collateral changes for OTC derivatives "would be bilateral versus cleared trading support; whereas in bilateral, there will be more stringent initial margin requirements, though there's also still the possibility for portfolio margining [to ease the initial requirements]; whereas in cleared, you're really working with whatever the calculated requirement of the CCP (central counterparty) is," says Joshua Satten, global head of OTC structured products at Northern Trust Hedge Fund Services. "We will continue to see advances based on the different CCPs evolving product offerings, in terms of what kind of margin relief and cross-margining with other products they may offer over time."
For example, Eurex recently introduced portfolio margining capabilities for interest rate swaps, as well as cross-margining between listed fixed income derivatives and OTC interest rate swaps, through which the CCP expects potential margin efficiencies of up to 70%.
Aside from portfolio margining, collateral services such as optimisation and transformation will be key to achieving efficiency and cost savings, particularly for larger firms. According to recent research by Deloitte, a firm posting US$800 million of average daily collateral in a 0.5% federal fund interest rate environment could save approximately US$1 million annually through optimisation, while smaller funds that post approximately US$100 million could save approximately US$116,000. As interest rates rise, savings would increase further.
"Factoring in the build and installation costs, an in-house optimisation capability seems more applicable for large asset managers and funds, as they can realise benefits of scale," says Deloitte in the paper. "While the analysis presented here is primarily driven by potential economic value, collateral optimisation can provide other benefits, such as tighter risk management, asset preservation, and liquidity management."
In addition to optimisation, several providers have begun offering transformation, whereby lower-grade assets can be upgraded to eligible assets via the securities lending and repo markets. "Looking at the competitive landscape, there's a lot of different players along the line that can provide value and that are trying to provide value," says Northern Trust’s Satten. "We've seen an uptick in companies acquire other companies as well as start complementary businesses; this includes clearinghouses, FCMs (futures commission merchants), middlewares, etc."
Firms that choose not to use an in-house system and/or go through their dealers for collateral transformation can also outsource these functions, which is where custodians are stepping in to offer collateral management services powered by a combination of proprietarily built platforms and third-party vendors solutions, such as Northern Trust using Lombard Risk's COLLINE collateral management platform. This trend is likely to grow, as 66% of custodians surveyed by Sapient said they either intend to or already offer some collateral transformation services. The difference in a custodian "being able to offer an overarching suite of middle-office administration and custodial services is that we're able to act as what I would call the ‘ultimate middleman’ in that we're able to see and provide support across middlewares, across FCMs, across trade repositories, and across regulatory regimes, so as to support the client holistically and globally in a manner in which I'm not sure other entity types are able to do," says Satten.
Sorting out the plumbing
Outside of these services, the collateral challenge could also be alleviated by central banks’ actions.
"Since regulation and the activities of some central banks has led to a decrease in collateral velocity, they may be forced to come up with schemes like a reverse repo facility that provides collateral..in different parts of the world, they will look at the issue differently, but the fact that you have the reverse repo facility from the Fed and the Reserve Bank of Australia's contingent liquidity facility tells you that they have acknowledged that, if need be, they will supply collateral or will do something so that the need for collateral or high quality liquid assets will be taken care of," says the IMF’s Singh.
However, these facilities also disintermediate what Singh calls the financial plumbing, in which dealer banks sit in the middle of banks and non-banks in order to move collateral and cash between them. "A reverse repo program allows non-banks such as money market funds to come in and get collateralised funding. If you do this in large size, you will rust the plumbing pipes that go between banks and non-banks," he says. If the collateral demand is phased out over a few years, perhaps the system will take care of itself, says Singh, but if the collateral demand comes all at once over the next year, there could be potential risks.
"If indeed this is not phased out and there's an impending need in the next year, you will find a reduction in some markets like the OTC derivatives,” he says. “To get a hand on good collateral, it might be too high a price, or the bank balance sheet space is not there for collateral transformation...There’s always a price for which you can get your hands on some good quality collateral. The question is, in a zero rate environment, when you're hardly making any returns, do you want to spend another 30-60 basis points trying to get high quality liquid assets? I don't know. If you're in normal yield curve where returns are 6-7% you don't mind spending 30-60 bps. But when you're making zero to 200 bps, you may just cut corners and not hedge, or not do derivatives and do hedges via futures [instead]."
Although quantitative easing may have had positive macroeconomic effects, its adverse effect is that it takes up balance sheet space at large banks, as non-banks deposit the cash coming from the Federal Reserve.
"The balance sheet at the large banks is not as freely available as it was five or six years ago, and you need that balance sheet space to move that collateral around, to do collateral transformation, etc. And it may not be worth your while to do it for a small client,” says Singh. "If the smaller players don't get the collateral and don't use OTC derivatives and go to futures or don't hedge, you’re not removing risk...The whole idea was to make the system safer. If you go through CCPs, you need collateral. Well, to get collateral you need to go to the same 10-15 banks who are adept at doing collateral transformation. So in a very ironic way, the same CCPs which you thought were safehouses, in order to get there, you're making the system more interconnected, because you need the 10-15 banks who do the collateral transformation. So we may be back to square one."