Market players discuss the changing landscape of the collateral industry
Regulation is often a catalyst for technological and operational change, how is the collateral
industry changing?
Todd Crowther: Collateral management has become more complex by way of regulation based on the proliferation in the amount of margined products and venues as well as the number of affected geographies and participants. Furthermore, regulation has also adversely affected the overall cost of collateralisation both in terms of the price of collateral (demand and supply) and the capital impact (or returns impact) to market participants.
Firms need solutions that offer simplified and centralised inventory and position management, a cost-effective and efficient means of processing margin exposures and the corresponding delivery of eligible collateral as well as optimisation tools, which enable best use of inventory and/or collateral.
Martin Seagroatt: Regulation is driving operational improvements in the entire end-to-end collateral process, facilitated by technology. As the number of firms impacted by collateral rulemaking expands this will continue to promote industry-wide change. The biggest change is the sheer amount of collateral required, particularly on the buy side. Collateral requirements have significantly increased due to mandatory clearing for certain asset classes of over-the-counter (OTC) derivatives as well as the collection of margin in respect of uncleared OTC derivatives between certain types of counterparty. At the firm level, different collateralised trading activities are converging into a centralised function and this is supported by technology solutions for managing global inventory and collateral across products in one place. This in turn is enabling a significant proportion of the industry to optimise collateral in some form or another.
We are beginning to see industry associations such as the International Swaps and Derivatives Association, the International Securities Lending Association and the International Capital Market Association facilitate collaboration between market participants on industry standards to meet the demands of regulatory reporting mandates such as Securities Financing Transactions Regulation (SFTR), European Market Infrastructure Regulation (EMIR), Dodd Frank and the second Markets in Financial Instruments Directive (MIFID II). The resulting improvements in data quality and management across the industry will lead to significant efficiencies.
In parallel to this, a more integrated and networked collateral ecosystem is emerging with the rise of peer to peer/all to all networks, collateral trading platforms, collateral highways and potentially blockchain solutions for mobilising collateral.
Graham Gooden: Regulation has intensified the focus on sourcing, mobilising, and allocating collateral optimally. As collateral moves from a largely back office function to an important component of front office decision-making, we are seeing corresponding changes in technology and operations.
Firstly, institutions are working on making their own processes and decision-making more efficient. Many sell-side firms are focusing on optimisation strategies, building algorithms that help them allocate collateral based on their own binding constraints.
Secondly, we see enhanced collaboration on common goals such as SFTR or Pledge, where industry participants are working with each other, technology solutions or service providers to define a ‘networked’ solution. These require broad adoption to be effective, and may face challenges in competing for finite resources given that mandatory requirements will take precedence.
Thirdly, emerging financial technology options are capturing the imagination with new, potentially innovative solutions. Commercial use cases and operational viability are hot topics as these options move from the hypothetical to the realistic and the impact on the collateral ecosystem is better understood.
Ted Allen: These are interesting times for collateral managers and many are turning the challenge of regulation into an opportunity for change. They have the attention and focus of their organisations they may not have had in the past. Collateral managers now demand a centralised view of collateral assets across securities lending, repo, OTC and listed derivatives and the tools to optimise how that inventory is allocated across lending, liquidity and collateral programmes. EMIR, Basel II, Uncleared Margin Requirements (UMR) and MiFID II combined have driven the industry to innovate to minimise collateral costs and to automate to handle the huge increase in collateral movements. Specifically we see three main trends: insourcing of lending programmes to maximise yield; insourcing and centralisation of collateral operations to minimise cost and ensure control; increasing use of market utilities: CCPs, triparty, electronic messaging and so forth.
David Raccat: The collateral industry is changing dramatically these days. Regulation is obviously pushing for more transparency, more price discovery, best execution, reporting to trade repositories, and all those initiatives are a very strong catalyst for technological innovation. Platforms have the ability to accompany the market into this journey and usually embrace those changes. Regulation is offering very exciting opportunities for technological innovation and is leading the market to the next level.
Roberto Verrillo: Following the 2008 financial crisis, governments and regulators instigated capital requirements on the industry which severely curtailed the availability and consequently the cost, of executing business. Secured financing, being a high volume low margin business, got hit hard and banks had to pass the costs on to their customer base.
Further regulatory pressures, mandatory margining of OTC products, Net Stable Funding Requirement (NSFR) and eventually SFTR are all aimed at increasing transparency and improving the resilience of financial markets but the unintended consequence is that it has a direct impact on the pricing and liquidity provided by traditional intermediaries.
The collateral industry is looking for solutions that can streamline and upgrade their businesses for this new world. From trade execution via all-to-all trading platforms such as Elixium to post-trade and margin processing and reporting.
How has the increasing use and developments with central counterparties (CCPs) affected the collateral marketplace?
Gooden: CCPs are a potential enabler for securities lending and continue to be the subject of ongoing discussion in securities financing. In the absence of a mandatory imperative, however, CCP adoption will be a very considered decision with the relative advantages and disadvantages reviewed by the whole supply chain. The benefits will need to be clear and compelling, as widespread migration to a new model will require a significant resource commitment, and widespread adoption will be needed to attract the critical mass that will ultimately deliver significant benefits.
Progress is slow but steady, with indications that some participants may move to CCPs for selective trades, counterparties or markets. For other activities, options such as pledge structures may offer similar benefits without the need to overhaul the existing end-to-end model or adding new participants into the system.
Verrillo: The use of CCPs to help access liquidity is clearly something which some counterparties may well find attractive. A number of buy-side firms are engaging with different CCPs in order to evaluate whether clearing the repo and swaps side of their businesses provides sufficient benefits—for some the CCP route to market may well be a preferred route.
Crowther: The phased implementation of mandated central clearing means that more products as well as more participants will be increasingly caught up by the requirement to post margin and manage collateralised exposures with counterparts. The global nature of these regulations means the process of margin and exposure management should now be managed holistically across different time zones, to strict regional cut-offs, along differing eligibility rule sets and over an expanding set of margin venues as well as individual account structures.
Allen: Central clearing has completely transformed the OTC derivatives markets. Now around 75 percent of all OTC derivatives by notional are cleared and although not all buy side firms are mandated to clear, still over half of the initial margin posted comes from the buy side.
In total the CCPs globally tie up about $750 billion in initial margin and default funds, primarily government bonds and cash. This extra demand for high quality liquid assets increases the value of an optimisation programme.
The decision to clear or not to clear for those firms that are not mandated is based on price, liquidity and cost of collateral and in the OTC derivatives world. More sophisticated banks are calculating Margin Value Adjustment (MVA) to understand the cost of initial margin at a trade level. Although the trend is not yet to pass this on to the end clients, this will probably change in the future.
What trends are we observing around the reuse of collateral?
Raccat: At the moment it looks like beneficial owners still do not benefit from re-use options, but we hear more and more lenders challenging the current model as their own collateral needs will dramatically increase with upcoming new regulations, for example, EMIR.
Crowther: It is difficult to see trends when there currently is not a lot of granular data available. This is currently proving to be a challenge in regards to SFTR reporting.
Verrillo: Collateral re-use can limit certain counterparties ability to access markets, segregation of collateral accounts for these counterparties are being looked at by tri-party providers.
Allen: We see the expansion of the use of triparty agents as the location for collateral across asset classes. This consolidation of collateral pools allows for operational simplicity, removes settlement risk and with the right collateral platform firms can monitor settlements and positions in real time. However we see increasing demand for solutions allow banks in particular to optimise their asset allocations across their triparty agents and their bilateral collateral requirements for all asset classes. The triparty agents will only have the view of inventory and log box within their domain but when firms have to allocate assets across more than one agent, to bilateral counterparties and to CCPs, they need a global view of inventory and an optimisation solution.
Gooden: Collateral reuse supports liquidity raising in times of stress and assignment of the right collateral to the right entity to facilitate optimal allocation. This is particularly important as firms seek to move collateral to different legal entities globally as they decentralise and fund locally.
Reuse could also be used to reduce the net collateral requirement firms must post for initial margin. Given that uncleared margin rules for segregated initial margin have resulted in a net increase of collateral of over $100 billion, firms are looking to reduce the sourcing costs of that collateral by reusing received assets as part of their securities lending or repo transactions.
Is the US still dominated by cash as collateral and Europe as equities? How does Asia compare?
Crowther: We are seeing increasingly strong demand for triparty connectivity (non-cash collateral) in both the US and Asia as the demand for more efficient means of collateralisation (and best use of assets/inventory) is trickling down to each region. Reg 15c3-3 in the US will certainly be driving some of this demand as the scope for non-cash collateralisation expands across a wider participant set.
Even before 15c3 comes into play, there is an increasing requirement for non-cash collateral management in the US relating to US Treasury and other fixed income collateral.
Verrillo: High-quality liquid assets is the focus of all markets given the aforementioned regulatory push, coupled with a drive for collateral and cash margin efficiency.
Gooden: In the US, we see a shift to non-cash fixed-income collateral where possible, backed by collateral providers who are eager for related capital benefits. Further, potential rule changes could eventually allow equities to be used as collateral in certain securities loans. Given available dealer equity inventories, that would significantly shift the US market to act more like the European model, and could result in some existing European and Asian business moving back to the US. Europe remains a mix of equity and fixed income as collateral, with regulatory-driven binding constraints dictating the mix of an individual firm’s financing strategies and assets deployed. In Asia, we see a balanced mix of cash and non-cash collateral. For cash, USD and EUR are the dominant currencies, followed by local currencies (AUD, HKD, and JPY). In non-cash collateral, JGB is most widely used followed by Hong Kong and Australian equities. We also see significant interest in unlocking assets in difficult-to-finance markets such as Korea and Taiwan and using them as collateral. These local markets require specific local solutions: we have worked closely with local institutions and regulatory and industry bodies to successfully develop and deploy these market solutions.
Raccat: The US market is still very much weighted with cash collateral, and the Fed rate hikes might consolidate this trend with increasing opportunities on the cash reinvestment space. In Europe and in Asia we see a lot of non-cash collateral axes, especially on the upgrade space, where lenders are pushing high-quality liquid assets government bonds against equities and/or corporate bonds as collateral. We also see an increasing pressure to post exchange-traded funds (ETFs) as collateral.
Have we seen any changes in clients collateral allocation and their available assets based on pre-established eligibility?
Gooden: Yes, clients are seeking to minimise the overall cost of posting collateral, considering the capital and liquidity impacts under various regulatory regimes. They are taking an ‘all in’ view of the cost of posting collateral with respect to its implications for risk-weighted assets, liquidity coverage ratio and net stable funding ratio, to name a few. This requires a holistic view of their global inventory, including the source of the assets (proprietary or client), to understand how they are priced or best allocated internally. This information is overlaid on asset quality, counterpart and tenor in order to make more sophisticated optimisation decisions that help clients retain existing business at profitable margins and compete for new business in an increasingly competitive market.
This front office focus on collateral must complement the operational requirements of running a collateral book. Translating a theoretical view of the most optimal allocation, based on that day’s binding constraints, to an actual and efficient operational deployment across multiple settlement locations and counterparties can be challenging. As a triparty agent, we see that challenge first hand, and work closely with our clients to provide tools and data that help them identify optimal collateral allocation and then execute efficiently.
Verrillo: Clients are increasingly willing to make high-quality liquid assets available for upgrade vs lesser quality collateral via collateral upgrade trades.
Crowther: This is a main focus for industry participants and one of the main benefits of our new CollateralConnect product. A technical solution to collateral efficiency has to be quick, easy to use, and intelligent in order to add true value to the process. Visibility and efficiency are central to the decision making process; the ability to make effective exposure coverage decisions around ‘what collateral needs to be used where and when’ is based on the multitude of factors that affect whether the decision is an optimal one.
What can technology do to take the market to the next level of efficiency?
Crowther: A better question is ‘what can’t technology do?’, to which we would answer technology has the power to improve any logical process. Nevertheless, as an industry we are cost constrained, hence the smart firms are increasingly looking for technology vendors to act as outsourced partners for development. These firms in turn benefit from delivered solutions which give the highest return for the most reasonable, socialised cost.
Allen: Securities finance and collateral management are now combined in many firms where collateral managers are able to achieve a big picture view of collateral assets supporting OTC and listed derivatives, repo as well as securities lending and potentially insurance collateral and other requirements. This requires enterprise tools that can operate across the traditional asset class silos. To operate effectively, these tools must have out of the box connectivity to CCPs, triparty agents, custodians, SWIFT and other electronic messaging platforms. Apex from FIS provides a single platform to manage, trade and optimise inventory across all the silos. Our clients typically see a five to 15 basis points drop in the cost of collateral and significant benefits from the efficient workflows and standard connectivity to market infrastructure. Savings such as these drive the business case to invest and renew technology.
Gooden: Technology solutions are key to increasing efficiency and scalability. They have been most successful when deployed against a specific problem, but we also see new technology driving a variety of services that can be plugged into the collateral ecosystem. Interoperability, industry solutions such as CCPs, vendor solutions, and the ability to assemble components into partially bespoke solutions are giving institutions more choices than ever before in managing their financing and collateral portfolios. The traditional supply chain is likely to expand to include non-traditional solutions; however, new options will require adaptation and adoption to be effective.
Regulatory compliance remains a principal focus of investment, with technology solutions being developed to meet SFTR reporting requirements (aggregation of data across multiple entities and data points) as well as inventory management as legal entity structural changes increase the bifurcation of collateral pools. We believe that technology and the efficient use of data is at the heart of any investment strategy and—for all the talk of disruption—view technology as an enabler.
Seagroatt: The regulatory reporting mandates are pushing the industry towards better data management and increasing standardisation of how data is reported from one firm to another. These improvements will lead to major operational efficiencies, especially when coupled with simpler views of complex data in one place, across business lines at the firm level. Initially, it looks like there will be a significant number of breaks in matched data reported through SFTR. However, as the industry adjusts to this it should result in a more streamlined process for everyone.
We are now also seeing more advanced pre and post-trade analytics around the impact of a specific trading activity, counterpart, client, trading venue or collateral selection on profit and loss, and once again this is driven by better quality data. For example, in derivatives trading, firms are starting to factor collateral costs into pricing and profit and loss, leading to margin value adjustment (MVA) calculations (MVA), although this is still a subject of some debate.
As artifical intelligence continues to develop, we will see predictive analytics that can utilise an ever growing volume of big data to guide collateral and liquidity management strategy. There is also still scope for greater automation in our industry; once again we will begin to see artificial intelligence driven robotic process automation solutions emerge to take a lot of the manual effort out of collateral management, freeing up time for strategic decision making.
Finally, solutions to improve collateral mobility will make it easier to get collateral to where it needs to be in a timely manner and to unlock idle liquidity.
Increasing volumes of electronic trading will also reduce manual effort and enhance straight through processing through the ability to better integrate a firm’s global inventory with opportunities to trade collateral in electronic markets and networks.
Raccat: Technology can help on multiple angles. Platforms can embrace the upcoming regulatory requirements around best execution, price discovery, transparency, reporting to trade repositories, and more automated and systematic risk management. Connectivity is another dimension where technology can help users benefit from operational efficiency and neutralised operational risk.
Finally, execution venues/trading platforms can develop machine learning and artificial intelligence to optimise dealer’s time, and help them focus on value-added processes. Those concepts are a bit new in our industry but so far have been very well received by individual users, who immediately see the benefits on the day-to-day activity.
Verrillo: Technology can help provide connectivity to new market participants and liquidity, as well as providing a centralised marketplace which provides for best price execution and through which all trade reporting and compliance can be achieved as well as providing for straight-through processing and connectivity to CCP’s and triparty service providers.
