A radically new market environment requires comprehensive data-driven digital collateral management

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1 Journal of Securities Operations & Custody Volume 7 Number 2 A radically new market environment requires comprehensive data-driven digital collateral management Michael Barrett Received (in revised form): 17th October, 2014 Genpact International Inc., 1155 Avenue of the Americas, 4th Floor, New York, NY 10036, USA; michael.barrett@genpact.com Michael Barrett heads Collateral Agreement and Reference Data Services (CARDS) at Genpact, a global leader in designing, transforming and running intelligent business operations. Michael has nearly 30 years of experience in banking and securities, with the last 15 years focused on global markets and global securities services encompassing global market infrastructure, global securities clearance and custody, and global securities finance including collateral management. He is a frequent speaker at industry conferences, and conducts basic and advanced-level collateral management seminars for Financial Markets World. CARDS is Genpact s collateral data service designed to help financial services firms realise cost-savings, efficiency gains, and operational and credit risk mitigation through a streamlined margin and collateral management process. ABSTRACT Global and domestic financial market players today fully understand that their world has changed. The financial crisis provoked a wave of complex, sometimes contradictory, and still unfinished rules and regulations ranging from Dodd-Frank in the USA to Basel III and the European Market Infrastructure Regulation on a broader scale. The reason for this, of course, has been to try to increase market stability and strength, improve transparency and accountability, and minimise operational, liquidity and counterparty risk. The result has been a global squeeze on collateral, prompting new demand for more efficient and cost-effective collateral management (CM) tools and processes delivered through an integrated operating model. Keywords: collateral agreements, digitisation, collateral rulebook, collateral management, collateral optimisation, margin, liquidity, capital Collateral management (CM) has abruptly emerged from its former, fragmented and neglected back-office status to become a critical part of financial institutions business strategies. In part, this has resulted from operational necessity. The web of new regulations is creating a scarcity of quality collateral estimated at anywhere from US$800bn (Bank of England) to US$4trn (the International Swaps and Derivatives Association) to as much as US$10trn (Bank for International Settlements). 1 Whatever the real number turns out to be, it is clear that the new challenges of cost-effective, transparent, efficient CM require new digital strategies to cope with rapidly changing rules and regulations. At the same time, it is also apparent that meeting these challenges effectively can significantly increase liquidity and access to collateral, decrease trans- Michael Barrett Journal of Securities Operations & Custody Vol. 7 No. 2, pp Henry Stewart Publications, Page 139

2 Comprehensive data-driven digital collateral management action costs, offer valuable insight into trading and other business operations, and even create an entirely new profit centre for many financial institutions. Integrated CM is now critical for effective liquidity risk management. As banks and other institutions move to boost their returns on equity and deal with a disappearing market for unsecured transactions, they will need more effective tools, systems and methodologies to maximise their ability to manage collateral for optimal value. Genpact estimates that billions of euros are being left on the table each year globally because of fragmented, opaque, outmoded and otherwise inadequate CM strategies. A recent Oliver Wyman/SWIFT study projects that new initial margin requirements will exceed US$1trn by 2018, and eligible collateral assets lying dormant need to be unlocked. 2 At the same time, a variety of research confirms that many institutions are maintaining too much collateral with too many settlement agencies. Regulatory changes will only complicate and intensify the need for more secured financing for longer periods of time, together with the need for accurate assessments of inventory and the total cost of collateral transactions, and therefore the absolute necessity of optimising CM. New requirements just those already known about that affect collateral liquidity include: increased capital adequacy requirements including higher capital levels, better balance-sheet quality and a longer, broader, list of risks to be covered; capital conservation and countercyclical capital buffers; increased capital and liquidity requirements for those deemed systematically important financial institutions (SIFI); new absolute leverage ratios to respond to failures of risk models; a liquidity coverage ratio that ensures institutions can handle a 30-day liquidity stress event; a net stable funding ratio that ensures more solid funding strategies and better matching of assets with liabilities; increased demands for improved transparency including more and better risk data and more-detailed reporting. ROOTS OF THE PROBLEM Institutions face a variety of operational, margin and collateral management challenges depending on their present practices and governing and corporate structures. Global investment banks, for instance, are more likely to have assessed the complexities and uncertainties of their operational environments and developed a holistic view of collateral asset classes; however, domestic institutions, despite a more narrow geographic reach and simpler business model, nevertheless may have neglected their margin and CM systems and strategies. Regardless of an institution s size and focus, fragmentation and siloing are common problems. Institutions may be organised into business units, each with its own divisions, and within these by function, or some variation thereof. They therefore may centralise or divide CM, but the most common models do not require or create data sharing, or an integrated, comprehensive view of margin, risk, liquidity and asset inventories. The result is quite often separate pools of collateral and margin that are monitored and managed individually and create a serious barrier to integrated management. Most importantly, institutions may have no single analytic tool or repository for storing and analysing the flood of regulations and transaction rules that can affect and degrade optimal CM. This situation means that far too many institutions do not have the man - agerial or structural capabilities that would minimise or eliminate serious internal Page 140

3 Barrett margin and CM inefficiencies. They generally have an incomplete overview of all collateral and the transaction and other rules that control it, and thus cannot manage it centrally to maximise liquidity, lower costs and lengthen the tenor of funding. Different divisions or business units may have different CM objectives and no way to coordinate or integrate them. This siloing may create inadequate, disparate internal transfer pricing mech anisms and the inability to perform accurate inventory assessments and projections. It may create excessive costs associated with moving collateral between business units or pools, IT interfaces that otherwise would not be needed and over-collateralisation. This complexity also may increase staffing requirements unnecessarily. ASSESSING THE REQUIREMENTS OF AN EFFECTIVE CM PROGRAMME Multiple industry surveys have shown that the major opportunities for critical CM optimisation will come if financial institutions move to eliminate their internal silos and management fragmentation. This means an insightful management process must be directed at the broadest possible range of assets, including equities, fixed income, loans, commodities and cash. Institutions are being forced to recognise that CM is central to optimal balancesheet management, and must be run in close collaboration with trading, treasury, risk and liquidity management, capital optimisation and portfolio management. This process has to involve implementation of a holistic, enterprise-wide CM system that includes a comprehensive IT solution that offers a complete overview of asset classes, business and legal units. Such a system would allow CM across business lines, asset classes and even across corporate legal entities. It would facilitate or enhance internal transfer pricing mechanisms that efficiently display the relative value of collateral in a comprehensive and timely manner. A comprehensive CM operation would develop accurate credit and counterparty exposure calculation engines that would show potential future exposures. In addition, any effective CM optimisation programme would have to create a centralised responsibility for liquidity and CM that would reconcile traditional conflicting division or departmental objectives. Front-office secured funding desks are usually looking to maximise profits, for example, while treasury divisions often manage liquidity for maximum flexibility, which can inflate the number and range of providers and liquidity pools. Finally, an effective CM system requires the ability to aggregate collateral data by asset class, location, encumbrances and currency. It must provide sufficient detailed data to meet business, counterparty and service-provider needs, and it must develop timely and effective connections and interoperability with providers to move collateral efficiently. THE NEW STANDARD: INTEGRATING MARGIN AND CM PROGRAMMES It is clear, in any case, that real-time margin management and intra-day CM are now business basics in order for financial service firms to survive and thrive. They must: manage dynamic margin and collateral eligibility rules; manage collateral across multiple counterparties, settlement systems, exchanges and clearing venues with diverse margin and collateral requirements, including distinctly different central counterparty (CCP) margin models, multiple and intraday settlement cycles and deadlines, and with the ability to know the real-time status of collateral at Page 141

4 Comprehensive data-driven digital collateral management any time and location, pledged or inflight; ensure their liquidity and funding capacity by making optimum use of their collateral supply chain (collateral optimisation); capture, mitigate and allocate collateral costs across products and businesses; manage margin and collateral, risk and liquidity with the same real-time capabilities found on the trading desks. To effectively develop these capabilities, a firm first must have a centralised margin and collateral rulebook that offers dynamic and on-demand data. This would be a central database that contains all counterparty margin processing and collateral eligibility rules derived from any counterparty agreement requiring margin and collateral exchanges. It would have the capacity to accept frequent changes and modifications, refreshing the database and the firm s own risk-weighted asset (RWA) rules for collateral eligibility. In short, firms cannot play the game without the complete rulebook in one accessible location. Integrated collateral and margin management also require a cross-business, cross-asset-class, centralised collateral inventory system that can display ondemand collateral availability, including inbound collateral to be received from counterparties. The underlying principle is the same as just-in-time inventory management across the supply chain. The supply needs to meet the demand in as close to real time as possible. A firm needs both of these tools to get the capacity and scale required to optimise CM and pretrade analytics, and to properly allocate collateral costs. A recent Elton-Pickford/Clearstream survey describes the difficulties that firms face in attempting to manage collateral and liquidity across multiple silos and inventory systems: The flows in the collateral-liquidity area can be described as chaotic. 3 Consider the potential cost and operational efficiency savings from re - placing multiple, siloed systems with an integrated, enterprise-wide platform and rulebook. For the firm and its clients, a single, integrated system would allow collateral and margin managers to tap quickly into the vast amounts of data contained in collateralised agreements and counterparty rules. This would be the basis for getting the highest and best use from a collateral inventory. It would offer an enterprisewide view of what a firm has, plus the accompanying rules that would allow that firm to quickly value and assess the appropriate value for any given asset. IMPLEMENTING A HOLISTIC SOLUTION Regardless of whether it is delivered internally or through a vendor, any good solution must enable buy and sell-side firms to automatically digitise and capture the terms and conditions of various collateral agreements across asset classes and counterparty types. It should integrate these data with counterparty and security reference data and CCP margin models as well as enterprise-wide collateral inventory sourced from systems across different lines of business. By using a platform with the intelligence to recognise and digitally extract these rules, firms avoid the need for excessive manual data entry that can be both expensive and time-consuming. In some cases, an institution may find that a combination of solutions is required to ensure they are comprehensively upgrading their CM programme. For instance, the combination of state-of-the-art reference data management tools with a collateral inventory management platform can allow firms to realise greater cost-savings, efficiency gains and operational and credit risk mitigation through a streamlined Page 142

5 Barrett margin and collateral management process that encompasses the entire financial enterprise. At the same time, robust enterprise margin and collateral operational models to handle the increased volumes of collateral exchanges and margin activity must be constructed by re-engineering the operations silos into shared-services enterprise operations models. To achieve further gains in cost-savings and efficiencies, consideration of what common operational functions can be provided by third-party service providers and what functions need to be retained for risk, control and compliance by the institution is a logical next step. As the CM landscape changes and requires an increasingly integrated IT solution, one thing remains certain: the CM programmes of yesterday will no longer work in today s markets. Institutions will continue exploring a variety of vendors and outsourcing solutions as well as in-house enhancements in order to find the best, most-efficient way of conducting their CM programmes. Firms ready to embrace change undoubtedly will find the path easier while those with long-standing, legacy CM methodologies may find they are institutionally incapable of managing on their own; however, given the degree of change necessary to modernise, it is a certainty that no firm s CM programme will remain untouched in today s market. REFERENCES (1) DTCC, Trends, risks and opportunities in collateral management, available at Downloads/WhitePapers/Collateral MGMT_Whitepaper.pdf ) (accessed 12th October, 2014). (2) Oliver Wyman/SWIFT, The capital markets industry: The times they are a-changin, available at: The_Capital_Markets_Industry_-_The_ Times_They_are_A-Changin.pdf (accessed 12th October, 2014). (3) Elton-Pickford/Clearstream, Collateral optimization. The value chain of collateral: Liquidity, cost and capital perspectives, available at: /9250c222407c9aad032ff51f8e4 befa3/eltonpickford-data.pdf (accessed 12th October, 2014). Page 143