Collateral management implementation: business model and culture are important, too
The focus on collateral management by both the buy- and sell-side has been one of the most important process changes that have emerged from financial crisis regulation.
By requiring exposures to be systematically collateralized — both in cleared and more recently in the non-cleared derivatives world — the need to manage and optimize collateral has come to the forefront. But — spoiler alert — the transformation is not always finished, often with the most important part — managing the business model and cultural issues — left to sort themselves out. It’s a problem.
There is no shortage of flavours of vendor solutions to help. They are easy to identify. Cloud based SAAS, systems inside a firm’s firewalls, software that integrates into existing front or back office systems or is completely stand-alone. You can spend a million or tens of thousands. They all have the same underlying premise: track exposures, figure out what collateral is eligible to deposit or receive, and then make sure the best collateral is used to mitigate any exposure. And by best, one should really think of that as the worst quality paper that still qualifies as per a CSA, repo and/or sec lending agreement.
Assessing which system is best can be complicated. To channel a past client, avoiding one major error can pay for the whole system, so making it intuitive to use is critical. Functionality between systems has largely converged to best practices, so the decision about which system to buy isn’t typically driven by whether it can do this or that. It is more about security, how a system is upgraded, the look and the feel of the GUI, responsiveness of support, cost and, last but definitely not least, implementation.
Security is the question every IT department asks. There is no one universal preference. A client might want their system to be within their firewalls, but still worry about how the technology vendor will be able to get in and fix bugs without creating a way in for less benevolent players. Having a system in the cloud, totally external and walled off, allows for more controlled interfaces, but also means systems are less customizable and it is harder to make modifications that are specific to a particular user. SAAS is more and more popular, not only for its simplicity, ease of upgrading, but also cost. But like cloud systems, your needs often have to fit into the box provided.
The look and feel of a system — the GUI — is critical. This is less about functionality and more about speed and simplicity of use. And it cannot be underestimated. But there is a bit of fashion involved here too. For a while, a system that looked like a smart phone app, versus an Excel spreadsheet (or worse), captured the imagination. Too many tabs littered across the top of a screen invite error. Firms that hired User Experience (UX) specialists to craft the look of screens reaped the rewards many fold.
Support personnel can, literally, be anywhere. But the relationship aspect of support should not be underestimated. There is no substitute for personally knowing the support personnel, not only the senior people but also the techs who do the work. Service levels will be higher, along with satisfaction. Plus it is nice to know the human being on the other side of a phone call, email, or text.
Implementation is one of those things that can be focused on to the point of obsession or virtually ignored. The cost of implementation for a big system, with lots of interfaces, can easily be higher than the underlying system cost it. Implementation can be done using internal resources. The advantage of this approach is that internal IT people probably have the best knowledge about the requirements to connect everything together, especially if those systems were built in house. The disadvantage can be time, money and politics. Often the technology vendor can also do the implementation, although it comes at an extra cost. They, of course, know exactly what their system needs and often have experience connecting to a variety of upstream and downstream systems — as long as they aren’t internal bespoke systems (in which case all bets are off). External implementation firms also can be utilized. They may be more time effective, as long as they aren’t reinventing the wheel in the process.
Ignoring implementation during the systems vetting process is done at one’s own peril. But obsessing about it probably isn’t a great idea either. The client who asked for the résumés of the people who would be doing the implementation work to vet them — probably 12 months in advance — along with assurances that those specific people would be available clearly falls into the obsessing category. But because it can be a huge cost and time suck, not integrating it into the decision is an equally bad idea.
And, of course, there is cost. Some of the most interesting solutions may be Software As A Solution (SAAS) and actually cost a lot less to take on. But the functionality of those systems can be very focused without a lot of customization available. You get what you get. Every client that needs to manage collateral is different in some way, however small. If you fit into that box, then more power to you. Technology wallet is never unlimited and only those willing to spend without budgets will get everything (and even then…). Prioritization between time, functionality, cost and across stakeholders will get you there, eventually. Sometimes those big, expensive, complex systems that can integrate cleared and non-cleared derivatives, repo, sec lending and who-knows-what-else could be cheaper in the long run.
Much has been written about the need to break down silos between business groups in the post-financial crisis world. It has typically been driven by the requirement to consolidate positions — which is no easy task. Firms need to make sure one group isn’t borrowing collateral externally when another internal group is sitting on that same paper. It is not hard to imagine when for years in big sell-side firms, repo traders hardly spoke to sec lenders, derivatives groups were in a world of their own, and fixed income wasn’t always sure what floor the equities people were on. But the issue impacts large asset managers too. Hedge funds without a centralized treasury function can find themselves in the same situation.
But once the system is in, the links to upstream and downstream systems completed, and personnel trained, there is still much to be done. For firms that have multiple portfolio managers, there is the issue of transfer pricing. One portfolio might be using derivatives and absorbing available collateral to satisfy initial and variation margin. Another portfolio might own the collateral that is in demand and should be paid for their trouble. There still is a major piece missing. Who determines the clearing price? In a business model that might be decentralized – repo, sec lending, equities & fixed income cash traders, and derivatives traders all occupying their own turf – there are bound to be issues. No one will like to pay for collateral and even fewer will be fine with not getting paid for the lock up of their securities or cash.
So who is going to run the transfer pricing? This is where business model and culture comes to the forefront. It may make sense to centralize this function – to create a collateral czar. But the process cannot be seen as simply creating a profit center to force feed internal bid-ask spreads. The collateral czar – if that is the appropriate term – should not be a profit center. Or at least not one who can be accused of favoritism or off-market pricing. It goes without saying, that having buy-in on what that pricing process is will be critical for success. Pricing collateral in this context is about valuing scarcity. This is a role that repo or sec lending traders have done for decades and that skill set should be mandatory.*
This pricing scheme also goes for cash. Cash is still the most common form of collateral used. There are lots of reasons for this and they go well beyond the most common answer (that with near zero or negative rates, cash may be the cheapest asset to provide). Collateral management systems, ironically, are very good at telling what security is the best to offer up, but rarely will they say that cash is better than securities. If cash is so common, and if the groups allocating collateral to cover exposure are rational, then there appears to be a disconnect. But I digress.
These musings don’t only apply to large firms, whether buy or sell side. The collateral management effort started with the sell side in response to regulatory changes, but quickly spread to buy side firms, including hedge funds and asset managers of all size and stripe. It has now spread into smaller firms who otherwise might not have gotten past the “manage it on a spreadsheet” model.** Hedge funds, in particular, have engaged in and expanded their Treasury management systems to include collateral management and related risk management functions. All of these observations have application to a broad range of market participants.
The job of pricing scarcity is central to making the whole scheme function. Imagine life without some sort of centralized authority to price scarce collateral? One can agree to simply not charge or pay anyone for collateral, but that only institutionalizes free riding. When conceptualizing the business model that supports collateral management, avoiding the pain of transfer pricing will only cause more problems down the road, especially in a world with greater collateral scarcity and rising interest rates. Identification, vetting, buying or licensing and implementation of a collateral management system are complicated tasks. But just don’t forget to finish the job.
*By way of disclosure, the author spent many years running emerging markets and corporate repo businesses so may be a little bit biased on who has the right skill set to price collateral movements… or not.
** One might be surprised how many firms manage collateral received and delivered on a spreadsheet. Hopefully that era is coming to a close.
This article was first published in edition 10 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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