Achieving capital efficiencies in today’s financial markets is crucial as participants look for ways to do more with less. So far this has largely related to margin levels, whether through portfolio margin across OTC and exchange-traded products or net margining across multiple asset classes. However, regulations will harmonise margin levels so participants will be on the hunt for other ways to make the best use of capital.

Collateral optimization: the future of collateral management

Achieving capital efficiencies in today’s financial markets is crucial as participants look for ways to do more with less. So far this has largely related to margin levels, whether through portfolio margin across OTC and exchange-traded products or net margining across multiple asset classes. However, regulations will harmonise margin levels so participants will be on the hunt for other ways to make the best use of capital.

Collateral management, while not new, will need to evolve to meet this demand and drive future capital efficiencies. Opinions and predictions differ on whether there will be a collateral shortfall and, if so, how great it will be. The reality will depend largely on how well these assets are managed. With increased collateral demands and a squeeze on high quality assets, the ability to optimize collateral in ways that are not related to margins will become highly valued. For many firms, this will mean managing the flow of collateral and their balance sheet usage in a more efficient way.

Firms that get this right and improve their collateral management processes will achieve significant benefits. These include more efficient management of collateral supply and demand; more accurate forecasting of the collateral requirements; greater insight into collateral shortfalls; the freeing up of valuation liquidity by avoiding over-collateralization; better optimization of cash; and more efficient collateral allocation between bilateral and cleared trades.

The collateral optimization techniques are still evolving in the industry and there are varying degrees of complexity to the process. However, one emerging model is balancing the supply and demand for collateral with sound risk management and minimal impact on the balance sheet.

The rise of cash optimization

The next step to delivering true collateral management is to optimize the cash flow. Nasdaq Clearing has already tackled this issue and from April this year, its customers can avoid double funding in respect of margin and settlement. All cash, including initial and variation margin, fees and premiums, will move into one settlement flow. As a result, customers can use any excesses in variation margin, for example, to offset deficits in initial margin. This will take into account all cash transactions and all posted collateral, both cash and securities, in the optimization calculation.

Crucially, the cash optimization process combines payments relating to cash collateral and daily cash settlement into one optimized flow. For any given custody account, this all adheres to clearly defined principles. These include that both cash collateral and daily cash settlement transactions are recorded on the same account; cash collateral on the account is used to cover daily cash settlement requirements (per currency); positive daily cash settlement is recorded on the ac- count to cover margin requirement (per currency); direct debit instructions are created for the account if a daily cash settlement requirement still remains after subtracting cash collateral and if there is a total collateral deficit on the account in the base currency.

Firms can create credit instructions for the account (with same day value) if there is a total collateral surplus in the base currency after the daily cash settlement is finalized. These instructions can then include both automatic cash collateral callbacks and positive cash settlement.

Market participants can also benefit from a high degree of flexibility as the service allows them to use their own preferences in ranking the currencies and deciding surplus levels. In addition, the model is based on a structure with full automation and straight through processing (STP). By optimizing cash flows and fully automating cash transactions in this way, Nasdaq Clearing’s customers gain true capital efficiencies.

However, there are still more gains to be made and the next step after cash optimization will be to implement tri-party arrangements and consider security optimization as part of ongoing efforts to optimize collateral.

Preparing a technology foundation

Delivering better collateral management will be subject to certain constraints – such as the time it takes to transfer cash and securities between parties. It will also depend heavily on technology. Dealing with the complexity of clearing requires greater innovation and this becomes highly relevant when considering open access and interoperability. Whether the latter becomes a reality soon is not yet clear. However, the drive to increase competition in clearing means that innovation in collateral management will have a marked impact on what participants choose to clear and, importantly, where they clear them.