Collateral management is facing increasing scrutiny as firms prepare for the wave of regulatory changes. The US Dodd-Frank Act, Basel III and the European Market Infrastructure Regulation (EMIR) are all set to send ripples through the capital markets. In particular, they call for firms to source and sustain higher levels of capital, placing new and significant demands on firms.
Collateral management is facing increasing scrutiny as firms prepare for the wave of regulatory changes. The US Dodd-Frank Act, Basel III and the European Market Infrastructure Regulation (EMIR) are all set to send ripples through the capital markets. In particular, they call for firms to source and sustain higher levels of capital, placing new and significant demands on firms.
Amid these changes, there is an emerging prediction that collateral management will become commoditised—with service providers looking to drive down costs to secure business rather than through functionality comparisons. However, is a commodity offering really what the market wants or indeed needs? Also, as high-quality collateral becomes scarcer, will a commodity product be able to withstand the demand?
For firms on both the buy- and sell-sides to maintain and even increase their activity levels in light of the changes, they will need to look to optimise their collateral. It’s uncertain at this stage how much collateral is involved in this equation. However, various estimates put this to the tune of trillions of dollars. The race for collateral is set to speed up and, as it does, firms will need to be focused on picking the best collateral in real-time.
Preparing for the new wave
The effect of new regulations in the capital markets will result in firms having to collateralise more contracts and also have higher liquidity buffers in place. Undoubtedly, demand for collateral—and particularly high-quality collateral—will increase dramatically.
Of particular note is the new requirement for central clearing of OTC derivatives under Dodd-Frank and EMIR. These will call for new measures from firms, specifically as central counterparties (CCPs) will require initial margin as collateral, the scale of which is expected to be significant. The question now is whether enough of this high quality collateral actually exists and, if it does, is it in the right place to meet the demands? Not only must firms have the collateral to maintain business levels but also to ensure that the markets are safer than before.
Adding to the issue of scarcity, Basel III’s new liquidity standards call for firms to have more high-quality assets, while some central banks have locked up collateral in their reserves as part of quantitative easing efforts. Some firms are chasing cash as eligible collateral through the repo markets and those seeking the securities alternative may find much of it out of reach at central securities depositories (CSDs).
One approach that is emerging amid this moving landscape is the possibility of creating the required assets. However, this ducks the issue. Instead of tackling the real problem of how to mobilise collateral, this looks at the worrying tactic of creating new collateral and new securities. The concept that repackaging securities is a viable solution goes against the very principles of collateral management. That is, collateral must be simple, high quality, liquid and easy to value.
Is a commodity product the answer?
As competition for collateral increases and uncertainty remains about where, and if, it might exist, collateral management is at a crossroads. SIX Securities Services recently carried out research into financial institutions across the UK, France and Germany. The results showed that 45 percent of financial institutions believe that collateral management is at risk of becoming a commodity, while a further 30 percent believe it already is a commodity.
Commoditisation is the move towards products and services competing on price differentiation, over and above other factors such as functionality, which have little or no differentiation. In the context of collateral management, the report gives an interesting view. Clearly, commoditisation suits certain markets well, particularly where there are uniform items such as petroleum or electricity. However, is it true to say this of collateral management?
Whether this was true before the crisis is no longer relevant. As regulations expedite change, collateral management providers must compete on a new level. Under particular scrutiny will be risk mitigation, operational efficiency and ease of use. It looks increasingly unlikely to go the same way as the oil or gas industries and become a commodity product. Instead, firms will look for providers with broader selling points.
Effective collateral management
Cost will always be a factor, however, it cannot be the only differentiator, particularly if we consider that collateral management must deliver far more than a single view from multiple collateral streams across silos. If the collateral management system is doing its job properly, firms will be able to control counterparty risk exposure efficiently and mitigate market and operational risks. The bottom line is they should make firms’ operations simpler, not just cheaper.
Firms have a range of factors to consider in terms of their collateral management. These include real-time counterparty risk exposures, knowledge of local markets and the quality of the on-boarding process. Also crucial are real-time and multiple asset class functionality, as well as an appropriate level of counterparty participation.
Triparty collateral management, where systems can completely ring-fence a financial institution’s assets, is a particular consideration. This approach protects the institution from the ‘co-mingling’ of assets so that if there is a default in the collateral chain, assets can be easily segregated, identified and returned to their owners.
In the new collateral management landscape, demand will centre on automated, comprehensive solutions that not only deliver on lowering total cost of ownership but also on enabling firms to source the best collateral. Firms will need flexible systems tailored to their needs and able to cope with an array of requests.
As competition for high-quality collateral increases, success will depend on bespoke services that effectively mitigate risk and provide real-time management. Those that equip themselves with the right resources and functionality will be in the best position to thrive and grow.
