Top five trends in collateral management for 2018

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This article was originally published on Securities Finance Monitor.

Collateral management has broadened far past simple margin processing; collateral now impacts a majority of financial market activity from determining critical capital calculations to impacting customer experience to driving strategic investment decisions. In this article, we identify the top five trends in collateral management for 2018 and highlight important areas to watch going forward.

The holistic theme driving forward collateral management is its central role in financial markets. Collateral has grown so broad as to make even its name confusing: where collateral can refer to a specific asset, the implications of collateral today can reach through reporting, risk, liquidity, pricing, infrastructure and relationship management. The opportunities for collateral professionals have likewise expanded, and non-collateral roles must now have an understanding of collateral to deliver their core obligations to internal and external clients.

We see a common theme running through five areas to watch in collateral management in the coming year: the application of smarter data and intelligence to drive core business objectives. Many firms have digested the basics of collateral optimization and are now ready to incorporate a broader set of parameters and even a new definition of what optimization means. Likewise, technology investments in collateral are starting to tie into broader innovation projects at larger firms; this will unlock new value-added opportunities for both internal and external facing technology applications.

Here are our top five trends for collateral management in 2018:

#5 Technology Investments

The investment cycle in collateral-related technology applications continues to grow at a rapid pace. Collateral management budget discussions are moving from the back office to the top of the house. And partly as a result, the definition of the category is also changing. Collateral management should no longer be seen as strictly the actions of moving margin for specified products, but rather is part of a complex ecosystem of collateral, liquidity, balance sheet management and analytics. The usual, first order investment targets of these budgets are internally focused, including better reporting, inventory management and data aggregation. The second derivative benefit of a more robust data infrastructure focuses on externally facing trading applications, including tools for traders and client intelligence utilities that provide real-time information and pricing for the benefit of all parties. This new category does not yet have a simple name, one could think of it as a “recommendation system” but regardless of name, this has become a major driver of forward-looking bank technology efforts and efficiency drives.

As large financial services firms capture the benefits of their current round of investments, they will increasingly turn towards integrating core innovations in artificial intelligence, Robotics Process Automation and other existing technologies into their collateral-related investments. This will unlock a large new wave of opportunity for how business is conducted and what information can be captured, analyzed, then automated, for a range of client facing, business line, internal management and reporting applications.

#4 Regulatory reporting

Despite being 10 years since the bottom of the great recession, regulatory reporting requirements for banks and asset managers continue to evolve. Largely irrespective of jurisdiction, the core problem facing these firms is aggregating and linking data together for reporting automation. Due to strict timeframes and complex requirements, firms historically relied on a pre-existing mosaic of technology and human resources to satisfy regulatory reporting needs. However, these tactical solutions made scale, efficiency and responsiveness to new rules difficult. The challenge of regulatory reporting is a puzzle that, once solved, appears obvious. But the process of solving the puzzle can create substantial challenges.

Looking at one regulation alone misses the transformative opportunity of strategic data management across the organization. Whether it is SFTR, MiFID II, Recovery & Resolution Planning requirements of SR-14/17 or Qualified Financial Contracts (QFCs), the latest initiative du jour should be a kick off for a broader rethink about data utilization. Wherever a firm starts, the end result must be a robust data infrastructure that can aggregate and link information at the most granular level. At a high level, firms will need to develop the capability to link all positions and trading data with agreements that govern these positions, collateral that is posted on the agreements, any guarantees that may be applied and any other constraints that need to be considered. Additionally, it has to be able to format and produce the needed information on demand. Achieving this goal will take meaningful work but will make organizations not only more efficient but also more future proof.

#3 Transfer pricing

As firms try to optimize collateral across the enterprise, it is critical that they develop reasonably sophisticated transfer pricing mechanisms to ensure appropriate cost allocations as well as sufficient transparency to promote best incentives in the organization. Many sell-side firms have highly granular models with visibility into secured and unsecured funding, XVA, balance sheet and capital costs. And in varying fashion these firms allocate some or all of these costs internally. But many challenges remain, including: how should all these costs be directly charged to the trader or desk doing the trade; and what is the right balance of allocating actual costs versus incentivizing business behavior that maximally benefits the client franchise overall. As we know, client business profiles change through time as do funding and capital constraints. There may be a conscious decision to do some business that may not make money in support of other areas that are highly profitable. Transfer pricing is evolving from a bespoke, business aligned process to a dynamic, enterprise tool. The effort to enhance transfer pricing business models continues to be refined and expanded.

Firms that embrace the next iteration of transfer pricing will achieve a more scalable, efficient and responsive balance sheet. This will include capturing both secured and unsecured funding costs, plus firm-wide and business specific liquidity and capital costs. Accurately identifying the range of costs can properly incentivize business behaviors beyond simply the cost of an asset in the collateral market. Ultimately, transfer pricing can be a tool to drive strategic balance sheet management objectives across the firm.

Functionally, implementing transfer pricing requires access to substantial data on existing balance sheet costs, inventory management and liquidity costs that firms must consider. Much like collateral optimization, the building block of a robust transfer pricing methodology is data. Accurate information on transfer pricing can then flow back into trading and business decisions to be truly effective.

#2 Collateral control and optimization

Optimization is evolving well beyond an operations driven process of finding opportunity within a business to an enterprise wide approach at pre-trade, trade and post-trade levels. Pre-trade, “what-if” analyses that will inform a trader if a proposed transaction is cost accretive or reducing to the franchise is important, but this requires an analytics tool that can comprehend the impact to the firm’s economic ecosystem. At the point of trade, identifying demands and sources of collateral across the entire enterprise extends to knowing where inventories are across business lines, margin centers, legal entities and regions. It also means understanding the operational nuances and legal constraints governing those demands across global tri-parties, CCPs, derivative margin centers and securities finance requirements.

In a simple example, collateral posted on one day may not be the best to post a week later; if posted collateral becomes scarce in the securities financing market and can be profitably lent out, it may be unwise to provide it as margin. A holistic post-trade analysis, complete with updated repo or securities lending spreads, can tell a trader about missed opportunities, leading to a new form of Transaction Cost Analytics for collateralized trading markets.

#1 Integration of derivatives & securities finance (fixed income and equities)

The need for taking a holistic approach to collateral management has led the industry toward significant business model changes. Collateral is common currency across an enterprise and must be properly allocated to wherever it can be used most efficiently. This means that traditional silos – repo, securities lending, OTC derivatives, exchange traded derivatives, treasury and other areas – need to be integrated. Operations groups that have been doing fundamentally the same thing can no longer be isolated from one another; the cost savings that come from process automation and avoiding operational duplication is too compelling.

On the front-office side, changes needed to impact trading behavior, culture and reporting to name a few are often very difficult to implement over a short period of time. Despite similar flows and economic guidelines, different markets and operation centers, even though all under the same roof, traditionally suffer from asymmetric information. To address this challenge a handful of large sell-side players have combined some aspects of these businesses under the “collateral” banner, sometimes along with custody or other related processing business. Others have developed an enterprise solution to inventory and collateral management. We expect that, more and more, management is seeing the common threads and shared risks involved. The merger of business and operations teams translates into a need for technology that can be leveraged across silos.

The business of collateral management is reshaping every process and silo it touches. While the trends we have identified are not brand new, they all stand out for how far and fast they are advancing in 2018 and beyond. Financial services firms that take advantage of these trends concurrently and plan for a future where collateral is integrated across all areas of the business will improve their competitive positioning going forward. To add a sixth trend: firms that ignore broader thinking about collateral management technology do so at their own peril.

Optimizing Your Collateral Resiliency and Recovery

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Balancing collateral optimization and regulatory compliance front to back through “Holistic Collateral Architecture”

July 28, 2017 

Collateral Business Transformation

Financial institutions today are increasingly evaluating how best to manage their collateral needs in the face of dual challenges – how to adapt their business and operational structures to become more efficient and how to respond to and comply with ongoing demands around changing regulatory requirements. These issues resemble a seemingly difficult task, like transferring passengers from one train to another, while both trains are in motion. Firms that approach front office transformation challenges, decoupled from regulatory and compliance challenge, will miss opportunities to solve larger systemic issues in a strategic and integrated fashion. We strongly believe that Technology strategy and architecture can play a critical role as firms evolve to meet these challenges.This article looks at how businesses can strategically address their collateral and liquidity management operations and regulatory needs by adopting a more holistic integration approach that takes into account their organizational complexity, unique business requirements and their compliance mandates. Firms that get this strategy right will establish a competitive advantage and maximize limited budgets by significantly enhancing their front office capabilities, while also meeting regulatory requirements.

Managing Business Transformations and Regulatory Challenges Simultaneously

Global regulations such as Dodd-Frank, Basel, MIFID and EMIR are demanding significant changes to securities finance and derivatives businesses which are primary drivers of collateral flow. An organization’s overall portfolio mix dictates the cost of doing business, and having an integrated view of the complete liquidity situation is critical and can’t be done in isolation. These regulatory and economic forces are driving firms to integrate their collateral businesses that traditionally operated as silos.

At the same time, new global regulations are mandating that firms implement specific capabilities and requirements that are often quite broad, impacting many aspects of collateral and liquidity management capabilities. Consequently, these requirements are quite onerous to accomplish especially because they need to be implemented at an enterprise level.

What is Required for Front Office Optimization?

Typically, financial business units were structured and incentivized to take a highly localized approach to addressing the collateral requirements for their specific business lines. This historical constraint was driven by a need for domain expertise and reinforced by budgeting protocols and performance expectations that were more closely aligned with local returns on capital, revenue and income. In the current environment, making decisions within a single function misses the opportunity to achieve broader benefits to drive valuable optimization across an enterprise. The outlying boxes in the diagram below illustrate the standard, localized organizations that exist in most firms today, where individual business units make collateral decisions without consideration of their sister business’ needs.

Firms that move beyond the silo approach and evaluate and prioritize collateral and liquidity requirements in a more integrated fashion across all their collateral management processes are better positioned to ensure the optimal allocation of capital and costs, realize efficiency gains and enhanced profitability. Some organizations are doing this by establishing collateral optimization units that have a mandate to implement technology and organizational changes across multiple businesses on a front-to-back basis. Potential areas that organizations are evaluating include maximizing stress liquidity, streamlining operational processing, reducing the balance sheet by retaining high-quality HQLA and improving the firm’s funding profile by reducing liquidity buffers against bad trades for non-LCR compliant transactions.

What is Required for Regulatory Compliance?

While many front office businesses typically focus on creating optimal technology architecture to improve financial return metrics, there are specific regulatory-focused technology enhancements that additionally need to be implemented. In most cases, these regulatory requirements are implemented by compliance and/or operations areas potentially away from the front office functions. This is a big challenge as these requirements are at the firm level and most firms don’t have a coordinated collateral architecture in the front. In particular, Recovery and Resolution Planning (RRP) requirements, Qualified Financial Contracts (QFC) specifications, Secured Financing Transaction Reporting (SFTR) are few examples that have pressing requirements and deadlines in the near future.

These regulations are creating significant demands on large institutions’ business and technology architecture:

  • Track and report on firm and counterparty collateral by jurisdiction (RRP – SR 14-1)
  • Track sources and uses of collateral at a security level across legal entities (RRP – 2017 guidance)
  • Conduct scenario-planning to simulate market stresses, such as a ratings downgrade or other environmental changes, that estimate impact on collateral and liquidity position in stress scenarios on a periodic basis (RRP – SR 14-1 and 2017 guidance)
  • Deliver daily information on their collateral and liquidity positions. Specific QFC (Qualified Financial Contract) reports will cover position-level, counterparty-level exposures, legal agreements and detailed collateral information. (QFC Specifications)
  • Report on all Securities Financing transactions (SFTR – Europe)

To fully meet these compliance deadlines within the next 12 to 24 months, most firms do not have the luxury of adopting a strategic approach to re-engineer their business and technology architecture and have been forced to take tactical steps to ensure compliance.  However, it is likely that achieving compliance in a short timeframe will create huge business and operational overhead costs, as one-off solutions may not be tightly integrated and may require additional manual work and reconciliations over time. The ongoing need for changes to front office business processes will have an impact on compliance solutions – potentially causing firms to significantly increase the operational overhead of supporting these businesses.

This can lead to a rather unfortunate outcome, in that costs for collateral businesses can significantly increase, despite working hard to drive cost & capital efficiencies.

A BETTER APPROACH – HOLISTIC ARCHITECTURE

Firms that choose to tackle these operational and regulatory challenges head-on and invest to create and establish an integrated collateral architecture across business lines will have a significant competitive advantage. In a dynamic marketplace where business needs and regulatory requirements are constantly evolving, a component-based architecture can be an effective approach. This allows seemingly complex processes to be managed through careful consideration of the distinct business and technology architecture elements of each stakeholder to achieve the appropriate balance for their strategy in an effective manner.

Key Components of Holistic Collateral Architecture

Here are some important drivers to consider in your planning:

  • Real-time inventory management capabilities across business lines that can be leveraged by both the front and back-office. This is a critical component of the strategic architecture, with the key requirement of knowing firm, counterparty and client collateral by jurisdiction.
  • QFC trades repository that is integrated across all Secured Financing Transactions as well as derivatives trades that can be linked with positions, margin calls and collateral postings.
  • Harmonized collateral schedules / legal agreements repository across ISDA, CSAs, (G)MRAs, (G)MSLAs, triparty, etc.
  • Enabling collateral traceability across legal entities with the ability to produce sources and uses of collateral will ensure regulatory compliance, as well as the ability to implement appropriate transfer pricing rules to drive business incentives in the right places.
  • Utilizing optimization algorithms with targeted analytics can maximize a variety of different business opportunities and most importantly recommend actions through seamless operational straight through processing.

This transition can be difficult for firms as it will need to cut across business and functional silos and it can have significant people and organizational hurdles along with technology challenges. One key point is that these changes don’t need to happen all at the same time and firms can prioritize the approach in a phased manner in line with their pain points and priorities as long as leadership is behind the vision of the holistic architecture. Many firms have started this journey and those who can make demonstrable progress in this evolution will have a significant competitive advantage in the new era.

How Transcend can help…

We have leveraged decades of Wall Street experience to develop strategic collateral and liquidity solutions for the largest, most sophisticated banks and financial institutions. Recognizing the unique requirements and opportunities financial organizations have to optimize liquidity and collateral across business units, we have developed solutions that address the need for Collateral Optimization, Agreements Insights, a Margin Dashboard, Real-Time Inventory and Position Management and Liquidity Analytics. Separately or in combination, these tools will help your firm take a more strategic approach to optimizing the best assets across your entire portfolio and businesses to maximize your profitability.

To discuss your firm’s requirements, contact us.

References:

  • January 2013: Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools
  • October 2013: Basel Committee on Banking Supervision Working Paper No. 24 – Liquidity stress testing: a survey of theory, empirics and current industry and supervisory practices
  • January 24, 2014: Federal Reserve Bank (FRB) released Supervision and Regulation letter (SR letter 14-1) entitled “Heightened Supervisory Expectations for Certain Bank Holding Companies,” and Attachment Principles and Practices for Recovery and Resolution Preparedness
  • SR letter 12-1 entitled “Consolidated Supervision Framework for Large Financial Institutions”
  • SR 14-1: Additional Guidance from Federal Deposit Insurance Corporation, Board of Governors of the Federal Reserve System entitled “Guidance for 2017 §165(d) Annual Resolution Plan Submissions by Domestic Covered Companies that Submitted Resolution Plans in July 2015”

Building a Holistic Collateral Infrastucture

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Following the financial crisis, regulations and their associated reporting have created an opportunity for banks and investment firms to create a single, unified collateral infrastructure across all product siloes. This does not have to be a radical architecture rebuild, but rather can be achieved incrementally.

There are legitimate historical reasons why collateral infrastructure has grown up as a patchwork of systems and processes. For products such as stock lending, repo, futures or contracts for difference (CFDs), the collateral/margining process was generally integral to the products and processing systems. It would not have made sense to break out collateral management into a separate group and hence operating teams and systems were structured around the core product unit. Generally, only OTC derivatives had a relatively clear decoupling between collateral management and other operational processes. Even as business units merged at the top level, this product separation at the collateral management level often continued.

While this situation could stand during non-stress periods, the financial crisis demonstrated the fallacy that siloed, uncoordinated collateral management systems, data and processes could weather any storm. This disjointed view caused a number of specific problems, including: an inability to see the full exposures to counterparties; a lack of organization in cash and non-cash holdings; and substantial inflexibility in mobilizing the overall collateral pool. Even before the crisis, inconsistent or “zero cost allocation” for collateral usage meant that collateral was not always being directed to the parts of the business that needed it most. After the crisis, with collateral and High Quality Liquid Assets at a premium, this became unacceptable.

Today, few banks and investment firms have completed the work of integrating their collateral management functions across products (see Exhibit 1). Some of the largest banks are focused on building capabilities to achieve enterprise-wide collateral optimization, while others are just starting on this effort, at least on a silo basis. Some have bought or built large systems with cross-product support, although this has proven costly. Others are evaluating organizational consolidation. Whatever their current state, a new round of regulatory reporting requirements in the US and Europe means that letting collateral infrastructure sit to one side is no longer viable to meet business or compliance objectives without adding substantial staff. One way or another, long-term solutions must be achieved.

Exhibit 1: Moving past the siloed approach

Source: Transcend Street Solutions

 

The next round of regulatory impact

While nearly all large firms have digested the current waves of regulatory reporting and collateral management requirements, the next round will soon be arriving. Among these are the Federal Reserve’s regulation SR14-1, MiFID II (Revision of the Markets in Financial Instruments Directive), and the Securities Finance Transactions Regulation (SFTR). It is worth looking at some of these requirements in detail to understand what else is being demanded of collateral management infrastructure and departments.

The Federal Reserve’s regulation SR14-1 is aimed at improving the resolution process for US bank holding companies. It includes a high level requirement that banks should have effective processes for managing, identifying, and valuing collateral it receives from and posts to external parties and affiliates.[1] At the close of any business day banks should be able to identify exactly where any counterparty collateral is held, document all netting and rehypothecation arrangements and track inter-entity collateral related to inter-entity credit risk. On a quarterly basis they need to review CSAs, differences in collateral requirements and processes between jurisdictions, and forecast changes in collateral requirements. Also on the theme of improved resolution rules are the record keeping requirements related to “Qualified Financial Contracts” (effectively most non-cleared OTC transactions).[2] These require banks to identify the details and conditions of the master agreements and CSAs applying to the relevant trades.

While the regulatory intent is understandable, these requirements are exceptionally difficult to meet without a unified collateral infrastructure. There is in fact no way to respond without a single, holistic view of collateral and exposure across the enterprise. While SR14-1 impacts only the largest banks, it still means these banks have a mandate to complete the work they have begun in organizing their vast collection of collateral information. This will lead to greater collateral opportunities for the big banks, and may in turn encourage smaller competitors to complete the same work in order to exploit similar new efficiencies.

Article 15 of Europe’s SFTR places restrictions on the reuse of collateral (rehypothecation). The provider of collateral has to be informed in writing of the risk and consequences of their collateral being reused. They also have to provide prior, express consent to the reuse of their collateral. Even with the appropriate documentation and reporting in place, a collateral management department has to carefully ensure that the written agreement on reuse is strictly complied with. While nothing is written in the US yet, market participants believe that the US Office of Financial Research will soon require mandatory reporting that may entail overlapping requirements.

Similarly, MiFID II introduces strict restrictions on the use of customer assets for collateral purposes and potentially has a major impact on collateralized trading products. A complicated analysis must be conducted on best execution, but in OTC and securities financing markets, best execution may be a function of term, price, counterparty risk and/or collateral acceptance. Further, any variation from a standard best price policy needs to be documented to show how the investment firm or intermediary sought to safeguard the interest of the client.

SFTR and MiFID II require that banks rethink their entire reporting methodologies, and in some cases must rethink parts of their business model. A wide range of new information must be captured, analyzed, consolidated, and reported outwards and internally. This will likely generate new ideas and business opportunities around collateral usage and pricing for those firms that can digest the large quantities of new information that will be produced.

A holistic foundation for trading, control, MIS and regulatory reporting

The struggle at many firms to comply with regulations while maximizing profitability has led to two parallel sets of infrastructures: one for the business and another for compliance. This creates two levels of cost that duplicate substantial effort inside the firm. Along the way, business lines get charged twice for this work as costs are allocated back to the business. This is an immediate negative impact on profitability; even firms that have completed collateral optimization immediately lose a piece of that financial benefit.

The cumulative impact of regulation means that banks and investment firms generally cannot afford to wait for consolidation projects to deliver a single integrated platform. The fragmentation of teams, data and processes are hurdles for any institution to overcome but so is the old mindset that simply thinks of collateral management as an isolated operational process.

We identify five critical areas for firms to address in order to create a foundation for their holistic collateral infrastructure:

  • Map the full impacts of regulatory and profitability requirements on businesses, processes, and systems.
  • Recognize that collateral management is an integral part of many key activities at the firm including trading and liquidity management.
  • Understand the core decision making processes at the heart of effective collateral management.
  • Organize and manage the data that is required to drive those processes.
  • Build a functional operating model for collateral management.

The fifth recommendation, building a functional operational model for collateral, means being able to connect together disparate business lines to provide an enterprise view of collateral. It includes mining collateral agreements to make optimal decisions or decisions mandated by regulation. It requires the ability to perform analysis of collateral to balance economic and regulatory drivers, and it requires controls and transparency of client collateral across all margin centers.

At Transcend Street Solutions, we are actively working with our clients to help them develop a strategic roadmap of business and technology deliverables to achieve a holistic collateral infrastructure. While there are always organizational as well as infrastructural nuances in every business, we have seen the framework proposed above yield a positive return for our clients. Our technology platform, CoSMOS, is nimble, modular and customizable to accelerate collateral infrastructure evolution without necessarily having to retire existing systems or undergo a big infrastructural lift.

Getting this right is important for more than just regulatory compliance. It means the collateral function and trading desks can perform the forward processes required to support both profitable trading and firm wide decision making. Pre-trade analytics is needed to ensure that collateral is allocated optimally across portfolios and collateral agreements. Optimization is also needed at the trade level to ensure the most suitable collateral is applied to each trade or structure. Finally, analysis needs to be carried out across the whole inventory of securities and cash positions to ensure collateral is used by the right businesses. After all, correct pricing of collateral across business lines is not only essential for firm level profitability but also incentivizing desirable behavior throughout the organization.

We strongly believe that firms that are successful in achieving a holistic collateral architecture will have a significant competitive advantage in the industry. They will be able to achieve optimization of collateral and liquidity across business silos while meeting most global regulatory requirements, and all that with a much more efficient IT spend.

This article was published on Securities Finance Monitor.