Collateral Management is becoming a strategic initiative for investment firms. Once exclusively a risk management and regulatory compliance effort, it is now also viewed as an opportunity to manage liquidity, avoid collateral drag, and realize returns from collateral transformations.
So far in Spain, Collateral Management has not really been the focus of much interest and investment, but with the Uncleared Margin Rules affecting more and more buy side entities in 2019 and 2020 this is likely to change.
When EMIR Variation Margin Rules came into force in 2017, financial institutions in Spain did review collateral management options available to them and most decided to manage their collateralization process in a fairly basic way, often using spreadsheets and a few resources working manually. It did the job given the relative simplicity of the function so far; using mainly cash collateral and often relying on the counterparty for margin call calculations.
As additional regulatory requirements are about to come into force for most of the Spanish entities, namely the Initial Margin (IM) requirements for certain non-centrally cleared derivatives, it is time to reconsider the collateral management programs and decide whether the manual process currently used are sustainable or this time it will be necessary to invest into efficient and scalable solutions, particularly for institutions that service underlying investment companies.
Until now, a relatively small number of firms have been affected by the Initial Margin requirement because of the high Average Aggregate Notional Amount threshold. However in 2020, this threshold drops from $750 billion to $8 billion. Many institutions will be impacted and although 2020 sounds far away, some market participants are realizing that time is running out given the complexity of the requirements that this phase of the regulation will impose on large sections of the market.. Failure to get ready by the deadline means that in-scope entities will not be able to trade non-centrally cleared derivatives. This could limit a firm’s access to the derivatives market and its ability to hedge risk while also potentially impacting liquidity.
Firms will need to look farther than the immediate necessity. What is needed and how to manage centrally, not only the collateral requirements, but also the risks and the liquidity in an efficient manner.
We need first to properly identify the inventory at group level, going over the silos that might exist internally between the different business lines. Once we have a clear picture, we then need to ensure that collateral is allocated on a “cheapest to deliver” basis, after evaluating its funding and opportunity cost. This centralized and integrated collateral management function can also identify opportunities to raise liquidity or enhance returns from transformation. This can be achieved by internalizing the search for collateral, collateral upgrade function, appropriate cash reinvestment as well as securities lending and Repos.
Furthermore, an efficient collateral management program should have the capacity to source required liquidity, such as High Quality Liquid Assets (HQLA) to meet margin calls in times of stress.
Those tasks are often made complicated due to the fact that legacy collateral management systems, in many case supported by spreadsheets, are unable to face the new need for real time information and dynamic analysis across a number of businesses, counterparties and systems.
Once we have envisaged all those new functions, we still have to take good care of the basics that include collateral matching and settlement, the ongoing calculations of margin exposures as well as addressing any discrepancies in positions.
It is therefore time to consider more efficient solutions that rely on robust but flexible technology and infrastructure. There are several ways to achieve this: insource, outsource or outsource certain modules or aspects of the collateral process that are not part of the Firm’s core competency.
Building in-house collateral management capable of achieving the more sophisticated functions described above in an efficient manner requires extensive collaboration throughout margin, treasury, funding, and trading teams with IT systems and governance to match. Only the largest firms are likely to fully insource and dedicate the required resources to this project.
Collateral Management outsourcing is a potentially valuable solution for firms looking to streamline a function that is not a core competency, giving priority in terms of resource allocation to their core business and to functions that directly impact business generation and client satisfaction.
A mix of insourcing and outsourcing can also be a good option depending on each firm’s objective and the level of control they want to maintain.
As firms select their optimal collateral management model, it is important to ensure the right organizational alignment to support an integrated and efficient collateral management function. The first step is to appoint a head of collateral management with a dedicated team that has a centralized, enterprise-wide view and can deploy a strategy to optimize available collateral, funding and liquidity. This is probably the key hurdle. Firms need to remove the internal silos to allow a holistic, firm-wide picture of globally available assets and obligations. It is also important to review the legal bandwidth, particularly to get ready for the Initial Margin requirement given the number of agreements that will have to be negotiated.
The capacity to manage properly the collateral requirements and comply with the regulation is dependent on many factors. In Spain, the collateral management function has been relatively under-developed so far. In turn this can be seen as an opportunity to draw an efficient model from the start and reach a highly effective way to manage collateral, funding and optimize liquidity, without having to rely on legacy systems and processes to do so. With the right support, Spanish entities have the opportunity to achieve this goal without distracting themselves from their core business. The main question is how shall a company best allocate the available resources. Which processes shall the company manage internally to better service the clients and for which ones is it best to look for a service provider that can deliver.
Column by Citi’s Benoit Dethier
Por Funds Society, Madrid