Nothing exists in a vacuum, even the untouchable collateral function
A buzzword of financial services, ‘optimisation’ is practically synonymous with ‘obvious’. But for collateral, so long forgotten in the depths of the back office, it’s only recently that banks are dusting off the inefficiencies and giving operations a spruce-up.
Of course, this attention can be traced back to regulation. With institutions forced to tighten their belts in all areas of their business, any improvement on efficiency, and any reduction in assets wasted, is welcomed.
Nick Nicholls, a principle consultant at GFT, and contributor to GFT’s collateral optimisation whitepaper, suggests that banks should take a more holistic view of the way they price their collateral. Currently, derivatives traders calculate cost of collateral with their counterparties and price this in to their transactions, while the optimisation process goes on behind the scenes, as back-office teams strive to meet the trader’s expectations.
“I don’t necessarily think all firms are looking at the whole picture,” says Nicholls. “Some of the tier-one institutions definitely are, and some are doing it better than others.”
“While some have been managing collateral as part of a holistic model it for years, many have yet to start, or are focusing their efforts in siloes or in support areas, rather than bringing the functional responsibility for managing the economics regarding collateral into a single cross-divisional trading area.”
He refers to the whitepaper, saying: “GFT is talking about breaking down the siloes and sharing an inventory pool across all the divisions; having one overall process, or a central hub for managing collateral as part of the capital, liquidity and financing arm.”
Such a structural change, however, will likely prove challenging. With so many regulations to address, and requirements changing so frequently, for large firms it can be hard to manoeuvre quickly enough to stay both efficient and up-to-date.
Ted Leveroni is chief commercial officer of DTCC-Euroclear GlobalCollateral, a joint venture intended to help firms identify, mobilise and optimise their collateral. He highlights challenges such as Basel III and mandatory clearing, suggesting that, although banks have made progress in enhancing their capabilities, “achieving the scale and technological capabilities needed before these regulations enter into full force is a complex undertaking for even the largest organisations”.
While focusing on the value of mobilising and optimising collateral, Leveroni suggests that some institutions might be better off looking to utilities to help them with their strategies—optimising the industry specialisation in order to benefit all players.
He says: “Firms should be carefully assessing what should be done in house and what is better left to a community based, utility solution which allows for the industry as a whole to solve these challenges once, instead of each firm coming up with their own individual solutions.”
Another provider of such a utility is Torstone Technology, whose Inferno trade capture platform integrates middle- and back-office processes.
According to Torstone’s global head of sales, Jonny Speers, the platform brings a certain sophistication to the way firms organise their collateral, bringing several data feeds together to generate collateral calls, while staying ahead of regulation.
He says: “Clients have been able to reduce the burden of regulatory compliance and avoid having to make the multiple changes required to in-house collateral management systems as additional regulations come into effect.”
Unsurprisingly, regulation is one of the most cited drivers for an operational overhaul. “Collateral optimisation has reached the top of the agenda following the global financial crisis,” according to Speers. “The move to central clearing … as well as margin requirements for uncleared derivatives, is forcing firms to think more strategically about how they manage their collateral.”
Leveroni points specifically to derivatives regulations as the primary driver, pointing out that these rules, while already a part of business-as-usual in the US, are spreading, and that institutions won’t be able to ignore them for much longer.
“In the US, central clearing has been underway for some time, while in Europe we expect to see similar mandates implemented towards the end of next year. Looking further afield to Asia, regulators are following closely behind,” he says.
However, sometimes it is the regulatory by-products that drive real change. Andrea More, managing director of the markets group at BNY Mellon, suggests that not only do regulations not mean the same for all institutions, but that a lot will depend on how much collateral they have to pay out.
More argues that collateral optimisation will be an important issue when a bank has several obligations, such as a number of currency and derivatives trades, and so may be unaware of the full extent of their collateral responsibility. She also points out that, for many institutions, optimisation is driven by a mandated move towards non-cash collateral.
She says: “A lot of the new regulations require segregation of collateral, and you cannot segregate cash in the European market. Cash is intangible, and it’s not considered as safe as an aligned physical asset in a depository.”
“Cash will become less common as collateral as it’s not an optimal asset any more—it will cost more than it’s worth to have it there.”
Similarly, Nicholls doesn’t place as much importance on regulation itself, preferring to focus on the benefits of change. While regulations may be a primary driver, they could be considered simply as the catalyst for things that, perhaps, should have been in the pipeline already.
“What banks should be looking at, now they have to manage their risks more closely, is how to do that more efficiently,” he says. “Without efficiencies throughout the collateral process, they’re going to lose a lot of money.”
He adds: “Core to this is transparency over the entire firm’s assets, and a business structure that centralises ownership and economic management of those assets. The more everything is in one place, the better the banks can see everything, the better their decisions are going to be, and the more adaptable they will be.”
But it’s an evolutionary process. It can be easy to assume a technology plug-in will revolutionise collateral management and solve the optimisation, efficiency, transparency and compliance challenges in one fell swoop, but, as always, the reality is much more complicated. Even technology providers concede that their offerings aren’t the definitive answer to the optimisation challenge.
Leveroni says: “While enhancements to technology and market infrastructures have certainly been a prerequisite to collateral optimisation, they are no longer the only means to improving collateral management.”
“The challenges we will face in the collateral space over the coming years will be quite substantial. Therefore all tools including technology, infrastructure, operational re-engineering, and standards will need to be deployed in a coordinated fashion in order to overcome them.”
Nicholls adds that, while technological developments can give collateral optimisation a boost, and provide a sustainable strategic framework for a core collateral hub, it can be the smaller, and cheaper, operational changes that make the big difference.
He explains: “A change in business process, however small, can bring dividends in terms of savings or cost reductions—even revenue in some cases. There can be a tendency to jump to a technological solution too quickly, when actually a lot can be done through process change.”
Taking a different viewpoint altogether, More points out that technology can only help if the existing processes are robust enough in the first place—the most important thing is knowing what collateral is available, and that comes down to a traditional back office.
“You can build computer systems, but if you physically didn’t receive the collateral in to that account, then you’re trying to optimise assets that you don’t have,” she says. “It’s not easy to connect the back and front office—there are a lot of reconciliation and data factors there.”
However, she accepts that, with the move away from cash as collateral, other assets move to fore, and with them come additional complexity and more data sets. Those systems designed to cope with cash are unlikely to be able to manage these factors.
But this kind of technology is not only in place for managing collateral, it also proves integral for credit and risk exposures.
If there is a change in the market, institutions have to be able to know what their exposures are, and more importantly, what to get rid of, as quickly as possible.
As More puts it: “Let’s face it—that’s a technology game now. No bank has staff that can file things that quickly.”
While many may know what they need to do—investing in technology or overhauling internal processes—for global institutions, having a plan is only half the battle. Even minor changes can prove a huge endeavour for the largest banks, and that can give more nimble firms a chance to get ahead.
“Small firms are likely to have fewer issues, and will have less of a vested interest in the siloed approach,” says Nicholls.
“They can be broken down more easily, and will have fewer systems, smaller infrastructures, and fewer people to gather around a table, meaning things can be sorted out faster.”
“Actually, the tier-two firms and smaller buy-side firms such as hedge funds are in a good position to make these changes earlier—they have much more flexibility.”
But that’s not to say that the big institutions aren’t making changes. There is movement among the giants, but it’s perhaps more calculated, more meticulously planned and, by necessity, implemented in a more staggered and cautious manner.
More concludes: “It’s a slow burn with some organisations, and some are just getting to the point where they realise they have to start looking at this. I don’t think there is a one-size-fits-all solution for all of them, or for every region. Everybody knows it’s not something they’re going to build overnight.”
