The New Age of Collateral Management

Abstract

What is driving the change in collateral management? Introduction of new rules and market changes from global regulators are putting immense pressure on financial firms to change the way collaterals are managed. With over 35% of financial firms facing compliance, administrative and reporting burdens (Celent, 2013), collateral management has become a top priority. It is no longer seen as a back-office function and requires new ideas—conversion of outmoded spreadsheet-based systems to an automated and advanced collateral management system—to deliver more value.

The Decade of Collateral Management

Collateral use in the financial market has increased. According to a 2013 ISDA survey , the estimated USD 3.7 trillion of total collateral in circulation is based on a total reported collateral amount of USD 2.67 trillion. Given the increase in collateral circulation, it is important for firms to implement robust, automated collateral management solutions to support evolving market and regulatory needs.

This paper provides insights into collateral management in the current economic scenario. It also provides a broader perspective on how regulations are driving demand for more sophisticated Technology. It also lists best practices that financial institutions must follow to improve the collateral management process.

Regulatory Fallout is Transforming Collateral Management

Collateral Management has undergone major transformation after the collapse of Lehman Brothers and the onset of the financial crisis. The credit crisis of 2008-09, along with the freezing of credit markets increased volatility due to the introduction of new regulations (BASEL III, CRD IV, EMIR and Dodd Frank Act) and high volumes of collateralized loans. In Europe, banks had a shortfall of Euro 374.1 billion (Quantitative impact study by Basel Committee, 2012) to comply with additional liquidity requirements of Basel III

With millions of dollars lost after the collapse of Lehman Brothers, industry demanded better collateral management. Industry initiatives required firms to consider smarter ways of using the limited collaterals available. Financial institutions were forced to focus on counterparty credit risk and the wide use of derivatives in the collateral management process. Regulatory changes also called for additional collateral and margin requirements for large and complex derivatives. The implementation of global regulations emphasized the automation of collateral management systems in order to manage them with ease. Automating collateral management systems mitigated systemic risk and increased transparency in Over-the-Counter (OTC) trades, and pre- and post-trade financial transactions.

However, to prepare for the changes, firms needed investment in technology. Technology helped firms in looking at collateral holistically and facilitated clearance. According to a 2012 survey by research firm Celent, an estimated 40-50% of OTC contracts are expected to be cleared by the end of 2013, leaving a USD 2.5 trillion to USD 6 trillion collateral hole to fill.

(Source: Morgan Stanley, Oliver Wyman, Celent)

The amount of uncollateralized credit available between transacting counterparties also fell sharply after the crisis. Decrease in uncollateralized credit increased the demand for collateralized credit, which in turn generated interest in the implementation of new processes and procedures for supporting collateralized solutions.

Once the market became stable, the capital market industry started considering collateral management as a core function, fully integrated in the management of financial institutions and closely linked to treasury, trading, risk management, operations, finance and capital management.

Essence of Collateral Management

Collateral Management has evolved over a hundred years from a single, ancillary function to cover a comprehensive list of functions and features in an organization:

Bi-party Collateral Agreement

In a bi-party agreement, two parties come to a collateral agreement without any interference from a third party or a centralized bank. These are over-the-counter agreements customized according to the needs.

• Tri-party Collateral Agreement
  A tri-party collateral agreement involves neutral agents who are intermediaries during the entire process and usually the custodians of the collaterals. They define operating procedures, terms and conditions, eligibility profile, concentration profile, and margin percentages. They also assist in transferring funds from the lender to the borrower.
• Collateral Trading and Re-hypothecation
  Collateral trading is done to free up resources for working capital requirements by the bank. Traditionally, it involves market participants and represents a small proportion of total trading. Re-hypothecation, on the other hand, is the process where the secured lender extends the collateral posted, by either lending or posting it as a collateral to another party.
• Repos and Repos Market
  Repo is an agreement in which one party sells securities or assets to the counterparty and simultaneously commits to repurchase the same at an agreed time. The repurchase price is equal to the original sale price plus interest on the repurchase price.

Reshaping the Collateral Management Landscape

• 1. Understanding Credit Considerations

  Structuring a collateral relationship involves the following credit considerations:

  • 1.1 Is Collateral a Suitable Credit Enhancement Tool?

    To determine whether collateralization is appropriate, financial institutions must analyze the counterparty’s financial position. The collateral should not turn a bad counterparty into a good counterparty without eliminating the credit risk. A collateral arrangement provides assets of value during counterparty’s default or bankruptcy/insolvency. If the direct counterparty defaults during the default period (prior to liquidation of the collateral), there is a significant increase in Mark to Market (MTM) exposure or decrease in collateral value held after taking into account independent amounts (initial margin) and haircuts on the value of the collateral securities.

  • 1.2 What is the Counterparty’s Credit Type?

    It is always helpful to determine the counterparty’s ability to:

    • Deliver collateral on a timely basis
    • Hold collateral
    • Measure collateral requirements on a daily, weekly, or monthly basis.
  • 1.3 How Appropriate is the Collateral?

    Upon successful completion of credit analysis and gathering of general counterparty information, the credit officer must determine whether the collateral is an appropriate credit enhancement tool. He must identify appropriate credit support terms to negotiate. In some instances, other provisions, such as guarantees or an option to terminate the transaction may be helpful.

• 2. Determining Eligible Collateral for the Counterparty
  • 2.1 Considerations for Selecting Appropriate Collateral

    Appropriately selected collateral gives financial institutions protection against counterparty risks and may reduce capital costs. Poorly selected collateral gives rise to unacceptable levels of price risk, liquidity risk, operational risk, and legal uncertainty.

  • 2.1.1 Liquidity

    Firms should consider credit rating, currency, issue size, and frequency of price updates to understand the liquidity of the collateral. If the price for a particular item of collateral is not available, the firm must interpret it as a significant downturn in the liquidity of that asset. It is advisable to establish a liquidity threshold below which an item of collateral is valued as zero

  • 2.1.2 Volatility

    Highly volatile instruments should be subject to lower concentration limits and higher haircut rates in order to be accepted. The haircut computation ensures that the price volatility is factored into the haircut. When establishing initial margin levels or haircuts, it is important for firms to understand that operational risk is generated by the delay between the time at which a margin call is made and the time at which the collateral is delivered. During periods of extreme market volatility, if the collateral call is made on day T while delivery of the collateral will not take place until T plus one day, a lag of one day will create operational risk. It is, thus, inadvisable to accept collateral subject to long settlement periods. Initial margin levels and haircuts should be established at all levels to take account of this risk.

  • 2.1.3 Collateral Quality (Credit Rating)

    A minimum acceptable credit rating is often stipulated for all bonds. If a bond is not rated by an agreed rating agency (e.g. S&P or Moody’s), the bond should undergo a deemed rating process. In deemed rating, firms must review ratings accorded by an agreed rating agency to unsecured issues by the same issuer, and accord a similar deemed rating if the issue in question is not subordinated. If the issue being assessed is subordinated, the deemed rating is two to three modifiers lower than the rated issue.

    Collateral quality is difficult to gauge for equities. However, listing on the major exchanges and especially in the prime indices (such as the S&P500, FTSE100, DAX30, CAC40 or Nikkei 225) is generally viewed as indicating greater liquidity of the collateral.

  • 2.1.4 Instrument Tenor (Time Remaining to Mature)

    Collateral is a group of tenor buckets with tenors measured as residual maturity rather than original maturity. Existing collateral agreements refer to original maturity but measure residual maturity suggesting a need to amend the agreement. However, in this dispute of original maturity vs. residual maturity, oral arrangement may not be enforceable

  • 2.1.5 Avoid Strong Correlation to Exposure

    Collaterals with strong correlation to underlying exposure are not appropriate as their value always decreases when the exposure increases. These collaterals are always unacceptable even if they qualify under all acceptability criteria. In certain circumstances, the collateral chosen may specifically offset the liability because of its strong correlation to the liability, creating a covered trade.

  • 2.1.6 Avoid Positive Correlation to Collateral Giver

    Any collateral whose value correlates directly and positively to the collateral giver’s credit standing is usually not acceptable. Securities or any related equity issued by the collateral giver is normally not accepted as collateral.

Bringing Efficiency to Collateral Management

Collateral management complicates the handling of relationships between two parties under one agreement for one line of business. A firm may be doing business with the same counterparty out of multiple entities in different jurisdictions for tax, accounting, regulatory or others.

In order to bring efficiency in the process, collateral management has to resolve the following issues that may arise because:

• A counterparty is initiating multiple calls for collateral to secure various exposures
• A call for collateral may be initiated by one entity while another entity is returning collateral to the same counterparty; at this time, both the parties run the risk of over collateralizing on a net basis
• Relations with counterparty may be governed by multiple agreements with different terms covering different products that may overlap

Firms need to automate the entire collateral management process. With automation, come additional administrative burdens in the form of monitoring or tracking the securities that are the subject of a collateral agreement, performing daily MTM calculations and handling margin calls.

Revaluing Collaterals

Financial institutions must revalue and monitor collaterals against outstanding debt on a regular basis. The frequency of revaluation will depend on two factors:

• Type of Collateral (Security or Cash collateral): Security collaterals include accrued interest for revaluation while cash collaterals exclude accrued interest for revaluation
• Market Conditions: Time, market volatility, finance availability, economic environment, lack of maintenance etc.

Maintaining Critical Buy-Side Relationships

Relationships for the buy-side are extremely critical for understanding collateral demands in both the bilateral and central counterparty worlds. Hedge funds, asset managers and insurance companies still look at primary service providers for the best deals across multiple products on a holistic basis.

Seeking Regular and Frequent Portfolio Reconciliation

Detailed portfolio reconciliation should be performed regularly or prior to the first margin call. If it is not done frequently, the collateral that flows back and forth is based on the estimate of the exposure, which is not considered a sound basis for collateralization. Regular portfolio reconciliation reduces the frequency of collateral disputes

Outsourcing Collateral Management

Fewer than 50% of firms have outsourced collateral management, 25% have deployed vendor collateral management solutions internally, with the remainder are reliant on bespoke applications and spreadsheets (ISDA, 2012). In an outsourced collateral management system, it is easy to retain bilateral relationships with preferred counterparties. The outsourced solution will also enable counterparties and investment managers to focus on strategies rather than worrying about the operational, regulatory reporting and transaction requirements.

Investing in Build-and-Buy Systems

Financial institutions struggling with collateral management and OTC derivatives must invest in plug-and-play type of systems. They can purchase or lease systems locally or via a hosted solution from a dedicated or a bundled service provider. The systems developed by service providers can be customized to meet collateral management needs

Regulations are Driving Demand for More Sophisticated Technology

Technology plays a critical role in collateral management systems. Collateral management requires compatibility and seamless integration with third-party platforms and applications such as Order and Trade Management, Trading Platforms, Risk Management Systems and External data feeds for running the business in a seamless manner. A centralized system can process and manage collateral requirements, and handle increased volumes and agreements with ease.

In the existing market scenario, technology:

• improves system efficiency
• prepares efficient systems capable of handling MTM calculations
• achieves cross product netting, collateral optimization, and management of new regulation requirements

Collateral management systems should evolve technologically with changing times and should reflect the true picture of the market. They should integrate all the critical functions such as business operations, legal documentation etc. to ensure that the system has core functional capabilities. A typical collateral management system should provide:

• integration with market data feed providers, third-party platform, and applications, and third-party institutions involved in collateral agreements
• scalability and economies of scale to handle increased volume of collateral
• capability to efficiently do MTM calculations, manage disparate systems, capture data from several sources, and calculate margin calls etc.
• risk management and alert mechanism with audit features to handle market volatility
• reporting capabilities to handle legal and documentation requirements

Collateral Management: From Back-Office Function to Front-Office Activity

The changing regulatory and trading environment has necessitated the need to revisit existing collateral management processes that involve integration with third-party institutions, platforms, and applications. It involves precision, accuracy, and timely flow of data to margin management and calculation systems. Any discrepancy in data can result in financial institution insolvency.

Collateral management is no longer a perfunctory back-office function; it is now considered a core function. Coforge with more than 15000 person years of experience in the capital market domain, has in-depth expertise in the area of collateral management, third-party feeds and data provider integration, enterprise data management, order and trade management, risk management, fund accounting, margining and netting, and reporting. Our solutions mitigate risk, process collateral information consistently across clearing methods and asset classes and meet new regulations and industry best practices to dramatically change the dynamics of the collateral management market. These strengths have led to a sizeable ecosystem with a large number of partners utilizing our collateral management systems.