Regulatory
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.”