EMIR Changes the Collateral Management Servicing Game: Costs and Considerations
Since the financial crisis began in 2008, the environment for market participants has become increasingly complex due to regulatory change under EMIR. There is a greater focus on counterparty risk mitigation and as a result, it is anticipated that more margin will need to be pledged to cover both cleared and uncleared derivatives. This has pushed collateral management to the top of the financial industry’s agenda.
The investments in technology and resources needed to upgrade a firm’s collateral management function present a significant challenge to clearers, custodians and clients. It is therefore unsurprising that many financial organisations find keeping up with the new regulatory changes both time-consuming and overwhelming.
When embarking on an overhaul of their collateral management processes, financial institutions generally have two choices: either in-house development through system upgrades or purchases, or outsourced solutions. The complexity of their business needs, time to market and cost are the decisive factors in making this choice.
In-House vs. Serviced: Differences and Considerations
Some market participants, in particular buy-side firms, may be new to collateral management and may be unfamiliar with the associated concepts and procedures. In fact, some buy-side firms have had limited experience in collateral management. As such, they would first need to introduce a collateral management function into their organisations as well as focusing on how to meet margin calls or regulatory requirements.
Managing cash as collateral is relatively easy and is normally a good starting point. However, cash has become a less attractive option in recent times in light of negative interest rate returns in some currencies. In addition, balance sheet constraints across most financial institutions have seen firms looking to maximise the use of their current non-cash inventory for initial margin (IM) or independent amount (IA) rather than invest in new assets. The process of managing collateral becomes more complicated with securities in particular if larger and more frequent margin calls need to be supported in the near term.
The use of securities, but also the general business needs of the firm in question, will require many to adopt more sophisticated collateral management tools. For instance, this includes the ability to conduct eligibility checks, analyse and process reference data as well as maintain cheapest to deliver algorithms. Investing in a collateral management system to manage these more sophisticated but essential functions is one option. However, there are very few ‘off the shelf ’ solutions that cater for each institution’s individual needs. More importantly, choosing a single system may limit the firm’s ability to pick and choose any additional functionality that it may need in the future.
Investing in in-house systems can also be expensive in terms of license fees, time and development resources, in particular if these need to be integrated with other messaging systems including SWIFT. These costs should not be underestimated, especially as they often add a fixed cost to the bottom line of the firm.
By comparison, it may be more cost-effective for a market participant to select an outsourced solution to avoid the costs associated with licensing and maintaining the system. Outsourcing generally reduces operating costs over time but it also allows a firm to reallocate manpower to more value-added areas such as dispute resolution or risk management. Firms that opt to outsource collateral management will gain access to more sophisticated collateral management functionalities such as collateral optimisation algorithms and funding services without having to buy in the experience that comes with it. Such advanced collateral tools may become increasingly necessary as the market and the needs of the different organisations within it evolve.
Costs: Qualitative and Quantitative
Outsourced collateral management solutions bring both qualitative and quantitative cost savings. Many operational managers may have groups that are using their current system but lack the expertise to upgrade it to handle greater volume or complexity. This is a qualitative cost that financial institutions should take into account when setting up their collateral management solutions.
From a quantitative perspective, we would expect our customers to be able to reallocate resources and therefore reduce costs by approximately 50 to 70%, even when taking ongoing service fees into account. Furthermore, outsourced collateral management services improve operational efficiency and reduce regulatory costs without sacrificing expertise or the availability of more sophisticated functionalities and tools.
Beyond Basics: Collateral Upgrades and Funding Support
The size of the demand for collateral upgrades or other transformational services is still completely unknown at this time. Some market observers argue that the extent of the predicted collateral shortage will only become clearer once the regulation has been implemented. However, we anticipate that firms will have different liquidity needs, i.e. some will be short of collateral whereas others will be long. It is important to recognise that variation margin still settles largely in cash. As result, the use of transformational services such as repo or securities lending is likely to increase as firms look to source the right type of asset for the right type of margin call.
In general, market participants will have to better manage their inventory positions by ensuring the allocation of collateral to the right location. This may not be an easy exercise as collateral could be spread across different venues and settlement management could become costly if not done efficiently or in a timely manner. Collateral allocation is becoming increasingly complicated as firms need to pledge more margin to support both cleared and uncleared derivatives. Using outsourced services is an easy way to build a centralised, efficient workflow to overcome the issues of collateral fragmentation. The resulting combination of eligibility screening and collateral mobilisation in turn enables a more efficient or optimal use of available assets.
Long-term Outlook: Reputation, Partnerships and Flexibility
Market participants can turn to various types of collateral management service providers such as banks, brokers and asset servicing specialists. The reputation of some commercial banks was damaged during the financial crisis and there is generally less confidence in their ability to manage collateral as optimally as some would like. As a result, some firms may want to reduce their exposure to these banking counterparties and therefore look for neutral third parties to manage collateral on their behalf.
As an International Central Securities Depository (ICSD), Clearstream is a safe service provider with a proven track record and decades of experience in both collateral and risk management. More specifically, the likelihood of our default is very low compared to a commercial bank. This is something that has been recognised by EMIR with the regulator mandating the use of CSDs (or SSSs) as the margin collateral location for CCPs.
As we are well aware that our clients are overwhelmed by the scope of regulatory change and need to retain their flexibility, Clearstream has looked to become a central hub for OTC derivatives. In addition to our trade repository services offered via REGIS-TR, we have added an OTC collateral service to our Global Liquidity Hub offering. OTC Collateral complements our triparty offering and takes a modular look at the world of bilateral collateral management. This allows clients to actively review their collateral lifecycle and to determine which parts need to be managed in-house and which parts could be outsourced. Outsourcing options include key functions such portfolio reconciliation, CSA administration and review, dispute management, margin transfers as well as settlement/reporting.
Partnership is a critical factor behind a number of initiatives that we have undertaken. The projects that we are implementing as part of the Liquidity Alliance* intend to support local collateral management services under local law. Clearstream’s role in these projects is to offer assistance, specialist knowledge and technology to each of the local partners. Our future objective is to create a set of interoperable ‘gateways’ across the different venues to maximise the opportunities that our infrastructural solutions present. This highlights that the importance of sound collateral management is transcending boundaries as well as regulatory regimes. In fact it is becoming an essential part of the daily toolkit that firms need to access. Outsourcing presents an efficient, cost-effective way of managing collateral. Infrastructures are getting ready, the big question is: “are you?”
*Cetip (Brazil), ASX (Australia), Iberclear (Spain), STRATE (South Africa), CDS (Canada), SGX (Singapore) and VPS (Norway)
This article was first published in edition 2 of Rocket, our magazine. Download your copy here, or save your address in your profile to receive a printed copy.
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