Collateral management is becoming a strategic initiative for investment firms. Once exclusively a risk management and regulatory compliance effort, it is now also viewed as an opportunity to manage liquidity, avoid collateral drag, and realize returns from collateral transformations. Various collateral regulations have come into play over the past ten years, encouraging firms to take a programmatic and strategic approach to collateral management. The Global Financial Crisis had a long lasting impact on how collateral is managed and ways in which collateral strategies can be implemented. Inadequate capital influenced the collapse of a number of institutions and the globally coordinated regulatory response highlighted the lack of risk management structures at the time. G20 nations’ commitment to devise an international regulatory framework for the over-the-counter derivatives markets and market participants continues with today’s ongoing effort to craft regulation that minimizes counterparty credit risk and widespread contagion risk.
Collateral programs continue to face regulatory pressure following the introduction of the uncleared margin rules in 2016, which require firms to post initial margin (IM) for certain uncleared derivatives. So far, a relatively small number of firms have been affected by these requirements because of the high Average Aggregate Notional Amount (AANA) threshold—a regulatory definition of material swap exposure between counterparties. However, in 2021 the AANA threshold for IM drops dramatically from $750 billion to $50 billion and drops again to $8 billion in 2022.
According to the International Swaps and Derivatives Association, at least 1,000 entities and over 9,000 trading relationships will be affected by the final phases of the IM rules. Many asset managers will find themselves among those included in the final phases, and firms should start planning now. Failure to prepare by the deadline means that in-scope entities will not be able to trade non-centrally cleared derivatives. This could limit a firm’s access to the derivatives market and its ability to hedge risk while also potentially impacting liquidity.
Collateral Management Roadmap
The continued focus on collateral management means firms should begin mapping out a programmatic firm-wide response, as the implementation could become complex and have significant operational implications. Firms should consider the following steps on their journey to an efficient collateral management program.
Select Your Solution
Market participants have several models for collateral management—insource, outsource, or modular outsource. Building in-house collateral management capabilities requires extensive collaboration throughout margin, treasury, funding, and trading teams with IT systems and governance to match. Given this, only the largest firms are likely to fully insource these functions, leaving most firms to outsource some elements of their collateral management program.
Collateral management outsourcing is a potentially valuable solution for firms looking to streamline a function that is not a core competency. A partial or wholly outsourced solution also gives firms access to a range of sophisticated management tools and analytics without the up-front fixed costs usually associated with building in-house. Modular solutions provide industry participants the flexibility to evaluate various components of their collateral program, retaining core functions and outsourcing to specialist providers that can enhance technical and operational expertise. When outsourcing a collateral management program, firms should consider the type of oversight required and which key stakeholders throughout the firm will be accountable for external engagement.
Technical integration is the foundation for a successful relationship with an external provider. Collateral management infrastructure should be flexible enough to incorporate workflow changes as well as keep up with rapid technological and regulatory change. Firms will want to ensure that the parties to which they outsource can implement continuous upgrades to complex algorithms to satisfy evolving regulations. New firm expertise may be needed as technology teams grow and product experts work closely alongside their various collateral management partners to define pre-set collateral optimization objectives.
Align Firm Structure and Resources
As firms select their optimal collateral management model, is important to ensure the right organizational alignment. Since collateral management was once a true back and middle office operational function, participants may find that the right talent and resources to execute their preferred strategy are not yet completely aligned. To ensure maximum efficiency throughout this process, firms should address three key issues.
- Dedicate a Team
Appoint a head of collateral management with a dedicated team that has a centralized, enterprise-wide view and can deploy a strategy to optimize available collateral, funding, and liquidity. This person should be empowered to reach across business lines and request necessary resources.
- Review Legal Bandwidth
Regulators recommend firms begin preparation 24 months in advance of the implementation date of the new phased-in margin rules. This is very likely to put a squeeze on legal teams within the firm as they work to negotiate the multitude of new documentation.
- Remove Silos
The greatest efficiencies can only be realized through a holistic, firm-wide picture of globally available assets and obligations. Management should work toward seamless integration across Risk, Operations, Technology, Legal and Compliance, as well as across disparate geographies, given the cross-border implications of new regulatory regimes.
Find the Right Collateral
Collateral management practices impact front-office activities. The choice of collateral can negatively affect investment performance, creating collateral drag. To understand which collateral to select, an institution’s full inventory across borders and among repositories needs to be considered. A single, enterprise-wide collateral pool will help guide decision making and can mitigate risk by preserving assets that could provide essential liquidity during stressed periods. Identifying and deploying assets that may be otherwise hidden in silos will help minimize costs related to accessing and securing collateral.
Further, posted collateral should be evaluated for both its funding and opportunity cost as “cheapest to deliver” can have multiple interpretations. The opportunity cost will be the lost benefit received if the collateralized asset was deployed for a different purpose. While it is difficult to quantify the drag that collateral lock-up has on overall returns, firms should consistently evaluate the impact of posting cash versus other instruments and ensure that they are regularly calibrating their cash reserves. It may be tempting to post cash as collateral if no other eligible asset is available; however, large cash buffers drag performance. Some jurisdictions have constraints for posting cash collateral. Cash may also be best preserved for other purposes, such as investor redemptions or new investment strategies.
High-quality liquid assets are in demand following regulatory changes and firms are likely to find optimal solutions by assessing collateral options based on their liquidity and grade. Variation Margin (VM) changes daily as it covers mark-to-market movements, and thus cash has been used as the primary source as it is easy to settle. Cash collateral may also be a requirement for VM in certain circumstances.
An integrated collateral management program can also identify opportunities to raise liquidity or enhance returns from transformations, such as:
Some market participants do not have to look far to source new collateral or liquidity. Firms with larger corporate structures or asset managers with sub-accounts at lower levels can trade collateralized assets without having to engage external counterparties. If risk is properly managed, firms can use their long inventory and client re-hypothecated securities to efficiently cover their collateral needs.
- Collateral Upgrade Trades
Collateral upgrades permit a firm to temporarily exchange assets of differing credit quality, allowing a firm to trade securities and raise high quality liquid assets to meet funding and liquidity requirements.
- Cash Reinvestment
Surplus cash can be reinvested to enhance returns and a variety of reinvestment vehicles exist that can be tailored to an investor’s unique risk profile and return requirements. Separately managed accounts, commingled funds, external investment vehicles, or lender self-invest models are common options. Firms will want to consider the size of the lending program, preferred levels of ownership, transparency, liquidity requirements, and influence on decision-making.
- Securities Lending and Repos
Firms may consider maximizing portfolio returns and enhancing yields through securities lending and repurchase agreements (repos). Asset managers, pensions, and insurance companies can benefit from the increased return securities lending can bring, especially in a low yield market where margin compression encourages firms to evaluate all revenue opportunities. With lendable assets at an all-time high and fees and cash reinvestment rates recovering to pre-Global Financial Crisis levels, firms may find that they could be putting their idle assets to better use.
A critical aspect of a holistic collateral management program is liquidity management to ensure the availability of High Quality Liquid Assets (HQLA) to meet margin calls particularly in times of stress. Partially driven by local regulatory regimes, many firms have liquidity buffers dispersed across various geographies and divisions likely creating a suboptimal use of these assets. Considering liquidity constraints and determining a hierarchy of uses for an asset can best be done when all of these pools of liquidity are brought into alignment and a risk based approach is taken to appropriately size buffers.
To maintain liquidity access, firms should consider diversifying counterparties between different tiers or regional providers. Investment management firms can benefit from accessing additional balance sheet capacity through new dealer relationships or more structured arrangements with existing counterparties. In addition, to minimize the number of relationships they have to put in place and legal agreement burden, some companies may want to consider leveraging an agency lending program.
Make the Most of Your Data
Often legacy infrastructure and technologies are unable to keep up with the new demand for real-time information and dynamic analysis across a number of counterparties and systems. Accordingly, market participants should revisit the foundations of their larger data strategy, and determine where there are opportunities to implement new analytic tools—either buying or building additional resources—to bring clarity to the myriad new positions they will be managing. Firms across the maturity spectrum of adopting data strategies can still benefit from ensuring their fundamental securities master data governance is well developed.
Fully leveraging the power of analytics is essential to gaining an information advantage and begins with an orchestrated firmwide effort around information governance and management. For example, firms may want to begin to harmonize data sources and consolidate to a centralized repository, ensuring that each unique product does not use a different reporting method or source. Cleaning and standardizing data are also preliminary tasks that not only enhance operational efficiency, but also underlie effective regulatory reporting automation. Firms will need to guarantee that data systems are built with a capability to link all trading positions and related data, and have a user-friendly interface that can quickly provide insights.
Oversee the Collateral Life Cycle
Monitoring the collateral throughout its life cycle supports ongoing analysis and allows the firm to determine its optimal use. These efforts include collateral matching and settlement, the ongoing calculation of margin exposures, as well as identifying discrepancies in positions. Monitoring can also encompass tracking collateral movements across the firm’s accounts in multiple jurisdictions and legal entities and reporting consolidated positions to view the firm’s entire collateral repository.
Oversight of the firm’s collateral can be improved through robust technology and infrastructure. Internal and external systems need to seamlessly connect with each other to manage, monitor, and report collateral at a security level in a near-real-time basis. The optimal infrastructure to build connections with service providers and market utilities would provide a common interface to deploy and reconcile collateral.
Compatible systems also enhance the onboarding process by removing unnecessary bottlenecks from the Know Your Customer, Anti-Money Laundering, and due diligence processes. The technology supporting collateral management should be robust, but flexible. As regulation evolves, systems will require enhanced ability to process different types of collateral and manage an increased volume of activity.
Around the Bend
Over the next several years, changing market conditions could impact collateral costs. Moderate global growth has suppressed demand for some forms of collateral while a relatively abundant supply of high-quality bonds and cash have been available. A rising rate environment, however, could negatively impact collateral costs. Over time, higher collateral expenses could create new supply pressures, particularly on high-quality liquid assets. General collateral shortfalls, however, may be unlikely in part because remaining market participants coming in scope are smaller firms whose positions will not have outsize market impact.
Collateral management innovation will proliferate as defined protocols to connect with vendors advance and standard calculation models and reporting templates come into play, rising to meet the demand of market participants’ shared needs. Firms cannot take the scenic route — collateral management complexity and opportunity will only grow over the next several years. Consistently revisiting landmarks including refining analytical capabilities as real-time data modelling advances and ensuring that monitoring adapts to regulatory change will be an ongoing effort. Firms will want to routinely evaluate their risk appetite and overall portfolio to navigate new solutions.