Regulatory pressures are forcing financial companies to take collateral management more seriously. Storme Thompson, of Catalyst Development, makes some predictions for the future.
The financial crisis of 2008 fundamentally shifted how firms manage their collateral. Numerous bank and country defaults, the use of disputes as a defence for non-payment and the market’s ensuing “flight to quality” have all combined to result in an unprecedented regulatory, media and political focus on the over-the-counter (OTC) derivative market.
With the subsequent sovereign debt crisis, the scramble for OTC client clearing and the emerging array of additional regulations, particularly in relation to the Dodd-Frank Act, the European Market Infrastructure Regulation (Emir), Basel III and the BCBS/IOSCO margin proposals for non-centrally cleared derivatives, the industry is moving towards a more front-office orientated solution for collateral management that allows firms to price the cost on trade execution and ensure they are not under-pricing risk.
Before 2008, funding and Libor spreads were such that many firms’ treasuries failed to see the benefit of collateral optimisation. But now, with diverging funding spreads and the acceptance of overnight index swap (OIS) discounting, firms need to clear trades in a way that maximises portfolio, product and trade offsets at a central counterparty clearing house (CCP) if they are to benefit from developments. They need not optimise collateral but to re-optimise it through time.
This new, highly dynamic environment means that in future, buy-side clients will need to be as flexible around collateral management as their banking counterparts.
Above all, collateral management is now a strategic function, positioned at the heart of decision-making in the OTC derivatives market. Firms that are not looking at the cost of collateral on trade execution could be selling derivatives at the wrong price and missing market share.
Based on our deep experience of collateral management, clearing, risk, regulation and technology, these are our top three predictions for the future.
Firms are moving collateral optimisation from a back-office function to an operating model that requires collateral valuation adjustment (CVA), optimisation, trading and treasury desks to work seamlessly together.
The liquidity and capital ratios of Basel III and the Capital Requirements Directive (CRD) IV are also impacting attempts to optimise collateral. As a result, collateral optimisation has become a complex process with interrelated functions involving multiple parties. CCPs, as a reaction to Emir, are adopting pricing policies that incentivise the use of “buffers” to disincentivise optimisation.
Banks now recognise the need to get collateral, as well as liquidity and balance sheet management, under control. Understanding the incremental impact to funding costs for each new trade, and funding this liability in the smartest way through their collateral optimisation model, will gain firms a pricing advantage over other participants.
Firms that do not have one view of portfolio offsets, initial margin calculation and collateral inventory and eligibility could be missing out on market share. Having visibility over this data pre-trade and knowing your costs better than your competition will create a competitive edge.
Gone is the old dimension of collateral management by asset class: the future is about understanding that collateral management needs to be put at the heart of the business.
Today’s systems are still, largely, risk engines of various degrees of complexity, with workflow engines that manage a trade life cycle. Once implemented at significant cost and time they can lock firms into a costly upgrade cycle.
At this stage, there doesn’t seem to be a proactive push from vendors to lead the charge on the next stage to transform collateral management. The market is certainly unsure as to which vendor systems are really changing the game. No-one yet knows who will shift from end-of-day to real-time and who will offer the collateral platform that builds a “collateral cloud”, provides real-time revaluation, blends collateral prices from multiple sources and provides an application programming interface (API) to drive collateral valuation in to the pre-deal price. An opportunity, perhaps?
Any organisation that does not have a good relationship with its regulators should address this now, if they want to remain competitive. Firms’ trading environment is consistently impacted by the burden of regulatory compliance, detracting from the “business as usual” goals of capital management, revenue generation, shareholder satisfaction and client service.
Unfortunately, most firms find themselves subject to multiple sets of rules from multiple regulators. These rules have conflicts, overlaps, gaps, inconsistencies and cost implications on managing separate processes to support compliance with separate rules.
Although regulators recognise that the industry cannot face conflicting rules without causing fragmentation of the global market, achieving compliance often seems an overwhelming challenge.
Compliance is also putting intense pressure on collateral operations for both buy-side and sell-side counterparties from a logistical perspective, often combined with an increasing need to achieve operational cost reductions while supporting new business initiatives.
Perhaps unsurprisingly, firms are looking to relieve the logistical and cost burden for operations in adopting current and future regulatory requirements. They are also asking: As the industry moves closer to the risk, will we see regulation killing off the OTC derivative market, as it becomes subject to higher financial costs, driven by added initial margin requirements over and above variation margin?
For mandatory cleared derivatives there is a new consideration on the level of collateral segregation needed.
“Protection versus cost” business strategies need to be adopted. These costs need to be included in the upfront pricing of the derivative to ensure firms are pricing-in the total cost of trading.
NEED TO ACT NOW
If OTC derivatives are seen as too expensive and the sell-side cannot see any revenue opportunities, a product may simply become unavailable.
What’s more, we are not convinced that there will be any appetite from buy-side firms to sell high returning assets to buy cash, in order to fulfil their regulatory initial margin obligations for non-centrally-cleared derivatives.
We also think that the market may well move to the futurisation of swaps – and if so, that the exchange-traded derivatives market may well benefit.
No one has all the answers to these issues. But experience shows that firms need to act now if they want to be sure to weather the next financial crisis.
Storme Thompson is head of collateral management at Catalyst Development
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