Collateral management for the buy side: time to take control?
Historically, collateral management has been a task that required complex infrastructure: initial margin value-at-risk (VaR) computations required a risk management system and extensive market data, OTC contract valuation required complex pricing capabilities, and margin call communication remained a very manual and time consuming process, using email and a fax machine.
These challenges led many buy-side firms to outsource the management to third-party administrators, but for reasons we will explain now, regulations have changed the game.
Initial margin (IM) VaR computation: there are a whole host of facilities that are now at the disposal of the buy side, provided by central counterparties (CCP) for cleared agreement, and by market alliance for bilateral trading, such as ISDA SIMM for example. A risk management system is no longer needed for IM VaR computation; you just need to be able to connect to these systems by sending your portfolio and receiving back the IM estimation. That should be more than enough to challenge the sell side.
Variation margin (VM) computation: the standardisation of over-the-counter (OTC) contracts no longer makes pricing computation a complex task that require pricing capabilities. Now it can even be imported by providers such as Markit or Bloomberg. At least, it has become easier to get a pretty accurate understanding of what to expect.
Margin call management
There are two aspects to margin call management; what to pledge to cover the exposure and how to communicate it. The pledging of the variation margin is a no brainer, exposure needs to be covered in cash, and most of the time in the currency of the exposure.
The pledging of the initial margin has been mostly made in cash on the buy side to date and there are a few reasons why. Firstly, buy-side firms do not always know in real time where their assets are and what is eligible according to each agreement. However, most fund administrators are now able to provide frequent and accurate security inventory reports. The key is to use these reports to reconcile security inventory in the portfolio management system, combining it with each agreement eligibility matrix in order to make a shortlist of available securities that are eligible.
Secondly, the workflow of margin calls was traditionally a manual process using emails and phone calls, which justified outsourcing due to the fact that it was very time consuming. We now see the emergence of new facilities to transform this process using electronic messaging, drastically reducing the time spent on margin call communication.
Lastly, margin call disputes were frequent and time consuming. There are two changes that should make dispute management more amenable. The most frequent source of dispute is around contract valuation. The fact that IM and VM are computed in a standardised way for vanilla OTC products will reduce disputes and relegate them to OTC custom products. Dispute management will therefore become easier via the electronic messaging workflow.
Pre- trade collateral optimisation
Traditionally, collateral optimisation was seen as a post-trade function. It consisted of either carrying out transformation, which is now diminishing as regulation restricts re-hypothecation, or optimisation by choosing the cheapest, lowest quality eligible asset available, which as highlighted earlier is easily accessible to the buy side.
Now there is another way to carry out collateral optimisation. Instead of focusing on how to meet collateral needs and what to do with the collateral received, it is all about reducing the collateral amount needed in the first place.
This is done by estimating how much extra IM is required with each counterparty for a given OTC order. Price is no longer the only factor. The extra IM amount is also taken into account. This is made possible by combining an OTC order management system (OMS) with connectivity to CCPs and IM computation tools.
The firms outsourcing collateral management are excluded from this key optimisation functionality as they don’t have the infrastructure to support it.
Increasing cost of outsourcing
Several factors show that both the number of credit support annex (CSA) and the number of margin calls are going to increase in the future. Mandatory OTC clearing will force market participants to find several clearing members for each clearing house to cover the potential default of the first clearing member. With each additional clearing member, come additional daily margin calls.
For bilateral trading, BCBS-IOSCO will force buy-side firms to set up collateral agreements and exchange margin calls on a regular basis with each counterparty.
Finally, the Markets in Financial Instruments Directive (MiFID) II introduces the concept of organised trading facilities (OTF). The order book trading of OTC products will increase the choice of counterparties a buy-side firm may have. Where in the past they used to deal with a small pool of preferred counterparties, the OTC order book increases transparency over pricing and may therefore increase this list of preferred counterparties!
Billing models used by collateral servicers is usually directly linked to the number of agreements and volumes of margin call. As seen above, both are expected to increase drastically and so will the outsourcing bill.
Technology to support buy-side needs
Now that you have decided to take back control of collateral management, you need to choose the right technology to make it happen. You are faced with two main options here: use a new piece of software that is independent from your portfolio management system, or use the collateral management module of your portfolio management system.
Taking a look at the independent software option, there are many vendors out there to choose from but the main problem from this approach is reconciliation challenges. These can jeopardise the crucial qualities you need from your collateral dashboard: realtime and accurate information computed on shared data between the front office and the collateral manager. This also excludes the pre-trade collateral optimisation option discussed earlier as you won’t have the connectivity to the IM tools in your OMS.
The other option is to use technology that integrates both the portfolio and collateral management functions, based on consistent market data, positions and valuation methodology. This technology should have a dashboard where you can follow the exposure you have with each counterparty across agreement types and the split between clearing members for each cleared trade. It should also have a real-time security inventory dashboard that tells you where your assets are on demand and what securities are eligible for collateralisation. Lastly, this portfolio management system should have connectivity to the margin call facilities to support margin call workflows. These are all qualities you should not compromise on to ensure efficient and cost-effective collateral management.
This article was first published in edition 5 of Rocket, our magazine. Download available Rocket editions here, and save your up to date address in your profile to to indicate your interest in receiving a printed copy of the magazine. Copies are also available to purchase and subscribe to via the shop.
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