change is having a significant impact on the way collateral is managed by
securities market participants, both sell- and buy-side firms. As a result,
we’ve been warned for several years that collateral requirements are set to
skyrocket, meaning more eligible, liquid assets will need to be accessible than
ever before, and more firms will have to put new procedures in place to
streamline movement and availability.
For banks, it is Basel III that many say has the capacity to create a shortage of high-quality liquid assets (HQLA). The requirement to hold HQLA on balance sheet – effectively to protect banks from future liquidity crises – means they will have fewer available assets to pledge as collateral, which will, in turn, cause the cost of pledging these assets to go up.
The liquidity coverage ratio (LCR) is, some participants say, particularly challenging, because it requires banks to take into account potential increases in market volatility that may impact the quality of collateral and/or future exposures resulting from derivative positions. LCR therefore potentially requires banks to apply larger collateral haircuts or additional collateral in such circumstances.
Topping the list of the buy-side’s concerns is the impact of this new capital and liquidity framework on the cost of services provided by their brokers. Many large asset managers and asset owners are hastily reviewing their options for accessing assets considered eligible for initial and variation payments to clearing houses, as liquid OTC derivatives migrate to central clearing, as mandated by the G20.
New solutions needed
Amid the uncertainty and struggles on both sides of the securities market, there is ample opportunity for new solutions. One approach to improving the efficiency of collateral flows could be through industry-wide standards. The absence of standards in today’s collateral-intensive environment is already becoming an issue, according to Virginie O’Shea, senior analyst at Aite Group.
“The lack of industry-wide standards for collateral messaging and data is a pain point, due to the operational risk and cost of manual intervention that is required to deal with email-based interactions,” she explains. “Firms may fail to respond to calls for collateral in a timely manner, because the process is reliant on staff members rekeying data received from counterparts via email, which is inefficient and risky.”
Because of the scope for clearing houses to call for more margin to support derivatives positions on an intra-day basis, for example, some firms are looking to manage collateral in near real time. But such efforts are hampered by the fact that the collateral value chain is very fragmented.
Sources of fragmentation are many, partly because of the range of uses for which collateral assets are required. But assets are also split by geography, based on where they were issued and registered. As such, market participants need to work with national central security depositories as well as global and local custodians to support their collateral management efforts.
Areas ripe for standardisation include data formats, margin calculations, platforms, settlement and dispute resolution processes, according to Guillaume Héraud, global head of business development, financial institutions and brokers at Societe Generale. “Standardising the way data is exchanged and increasing the speed at which information can be integrated will reduce the possibility of error and the risk of generating disputes, which is costly and time-consuming,” he says.
“We can see that standards are emerging at different levels, but implementing new standards is expensive with the inherent risk that they are not globally adopted, lessening the savings and efficiency benefits. Firms will inevitably analyse the costs versus expected benefits and their decisions may not always lead to adoption.”
Taking a holistic view
One approach currently being mooted is a global collateral inventory. When using existing channels and infrastructure, many firms struggle to move collateral assets between siloed pools in a timely and efficient manner, resulting in both an increase in cost and operational risk. O’Shea says that this problem will be exacerbated as more jurisdictions enforce OTC derivatives regulation, notably the introduction of central clearing, compelling a wider range of firms to manage collateral assets more actively across regions.
“A global collateral inventory could allow firms to see the location of every collateral asset, including cash in transit, and to centrally manage all margin calls in one place,” she adds. “It will, no doubt, be challenging to connect all of the global collateral pools due to the lack of data standardisation and infrastructure differences. The challenge a central services provider for collateral management faces, is that such a service needs to not only be operationally efficient but also cost efficient.”
Héraud concurs: “The challenge in building this holistic view on available assets is to have it updated in a near real time, taking into account the collateral to be received and sent, substitutions and those assets that have already been allocated. But having this global inventory is in fact worthwhile as it is the prerequisite to cross-asset collateral optimisation, ensuring firms’ ability to make the most of their assets,” he says.
Market structure operators and service providers, notably central securities depositories and global custodians, have been working for the last two years or so on providing broader and simpler access to clients’ assets. “There is evidence that the industry is shifting towards a more standardised environment,” says Héraud. “If collateral management remains too costly and difficult to operate it will negatively impact business.”