In a special feature story, FTF News focuses on the requirements and impacts on a firm’s incumbent operations, systems, and staff of a new collateral management strategy.
Post-crisis regulation and competitive market conditions have forever changed the collateral management process for securities trading firms. The push to develop new collateral optimization strategies has often uncovered major problems within a firm’s own systems and processes.
Most firms have had to move quickly to revamp their internal systems and craft new collateral management operations because of the many looming deadlines and new capital frameworks that are the new reality.
The time-line for developing or revamping current collateral and/or margining strategies is tight. For 2018 and beyond, there are collateral, margining and related deadlines coming via the CFTC, European Market Infrastructure Regulation (EMIR) rules and guidelines, the onset of MiFID II/MiFIR regulation, and the new regulatory frameworks of the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) — just to name the major milestones.
But what are the building blocks of a new collateral management strategy? And what are the impacts of a new strategy upon a firm’s incumbent operations, systems, and staff?
FTF News has reached out to industry participants to get their insights into the new environment of collateral management.
The Impact on Operations
More than other areas of securities operations, the definition of collateral management and its relevance within a trading enterprise have undergone the most significant changes since the Great Recession. It is no longer a back-office afterthought but an enterprise-wide effort.
The full measure of the impacts of the new collateral management will depend upon “the size and type of the financial institution,” says Scott Linden, managing director, collateral management for Wilmington Trust. “Obviously, the larger financial institutions will be dealing with bilateral IM [initial margin] and many new counterparties. For some smaller financial institutions, they are dealing with the mandated collateralization on deliverable FX [foreign exchange] forwards in January and TBA and mortgage forwards (mid-2018).”
While certain issues may be dominant for particular firms, there is likely to be a laundry list of operational challenges for many firms, says Lisa A. Cavallari, director of fixed income derivatives and commodities at Russell Investments.
Firms will have to juggle the timing of different rules “coming online globally” while there’s also likely to be an intersection of regulatory and collateral reporting requirements, Cavallari says. There will also be overlapping and conflicting operational chores as the need for collateral increases across the firm. For instance, some trading counterparties may prefer cash put up as collateral while a firm’s clients may want non-cash as collateral, she says.
There’s no question that the new collateral management rules are putting a greater burden on the existing collateral management team.
“Collateral Management operations needs to be automated in order to achieve scalability and meet the demands of high stress/high volume trading days when volumes can reach ten times the norm,” says Christopher Surh, lead technical product manager for provider Openlink. “Having tools that can automatically assign collateral based on agreement rules, allocate them most efficiently and create movements and messaging is essential,” Surh says.
Building a United Response to the Impacts
As the bottlenecks become exposed, incumbent collateral management teams are beginning to reach out to other internal groups of a trading enterprise. They are also reaching out to find third-party IT systems to ease the collateral problem.
“The problems are becoming more complex,” Surh adds. “IT solutions are needed to perform complex calculations and cut costs. For example, the ability to compute initial margin by adopting a SIMM [the ISDA Standard Initial Margin Model] methodology can cut margin requirements significantly, as compared to the simpler ‘Percent of Notional’ approach.”
The collateral effort within a firm “touches IT, risk, compliance, legal, portfolio managers and front- and back-office teams,” Cavallari says. The collateral management team members face many burdens as “they need to accommodate each fund or client’s need in terms of desired collateral posted and received.” They also have to make certain that the front office sales and trading staff have collateral available for desired trades. If that weren’t enough, they also have payment responsibilities, and must “make sure everything is reported correctly,” Cavallari says. Collateral teams may also have to find and manage third-party valuation service providers.
All parties involved in collateral management generally need a “document management system (for legal agreements that encompass collateral) [and] appropriate portfolio management systems that enable the collateral teams to view portfolios holistically,” Cavallari adds. In the legal department of most firms, “there can be significant documentation requirements.”
Diana Shapiro, NAM head of OpenCollateral at Citi, agrees that collateral management has grown in importance and that collateral teams will need to work with key segments of the firm. “In order to have a cohesive and comprehensive collateral management strategy, it is important to involve different areas of your organization,” Shapiro says.
Some areas that are likely to be included in the collateral effort are operations, which may encompass internal middle office and collateral management teams. Outsourced service providers, the risk management group, compliance and technology are also part of the new dynamic, she adds. “While the specific objectives of these teams will vary, it will be critical to put in place technology that collates collateral data and allows the stakeholders to assess the information in real-time to make business decisions,” Shapiro says.
How the aforementioned teams, groupings and outreaches will ultimately be organized is firm specific, Surh says. “The trading desk, for example, has a large part to play as well. They need to factor in the margin and operational costs of managing the full lifecycle of the trade as part of their pre-trade analytics and pricing,” he says.
Toward a Modern Strategy
As firms begin the challenging process of revamping a collateral management strategy, they should keep in mind that the effort is a marathon not a sprint, Surh says.
“Adapting new technologies to deal with the all-around complexities of collateral management can take a firm two years or more to design, test and implement,” Surh says. “So, given the compliance dates that are looming for the remaining segments of the market, now is absolutely the time to start moving — before it’s too late.”
Shapiro adds that collateral management strategies “should not be stagnant and should be adjusted as driving parameters change.” But she would prefer that firms take things a step further and reach out across the trading enterprise.
“When firms are revamping their collateral management strategy they should look to collaborate across multiple areas of the firm as well as service providers to ensure a cross-functional and cross asset view,” Shapiro says. At the same time, firms will have to take into consideration “multiple paradigms such as (but not limited to) the firm’s investment objectives, operational capabilities, and collateral holdings.”
Firms may also want to have as a governing principle the fact that collateral should be seen “as a part of portfolio management,” and that a process has to be in place for “choosing the optimal collateral per account,” Cavallari says.
Consultant Jeffrey M. Bandman, principal of Bandman Advisors, affirms Cavallari’s assertion that collateral issues are no longer solely controlled by the back-office staff. “Collateral optimization decisions should be part of front-end trading and funding optimization analysis rather than an after-the-fact process,” Bandman says.
Before a collateral management process is revamped, though, Bandman says that firms should focus on exactly what aspects can be completed in the present and what aspects need to be completed over a longer time-frame.
“I think that while the regulatory landscape is clearer than ever, there are enormous technology efficiencies that should be available within three to five years, but are not sufficiently developed (or vetted by regulators),” Bandman says. In particular, blockchain/distributed ledger technology (DLT) and cloud technology need more due diligence.
“One of the key open issues on cloud is what confidential or proprietary customer data may be stored there,” Bandman says. “And can you achieve operational efficiencies of collateral tagged to individual customers while protecting data integrity and information security?”
The bottom line for Bandman is that “funding optimization is more critical than ever in today’s competitive environment.”
But as firms push to optimize collateral management, they need to apply strong governance and oversight to sidestep pitfalls that could derail a project.
It’s likely that to avoid future pitfalls, firms need to “implement flexible systems to future-proof against changes that are likely to happen as a result of additional regulatory changes and reporting requirements or even a roll-back of some of the restrictions in place today,” Surh says. “Backing oneself into a corner will never enable firms to achieve the operational efficiencies and cost savings that we all are striving for over the long term.”
The right governance may provide much-needed clarity.
“In order to avoid pitfalls it will be important for firms to put in place proper project governance, including appropriately defining their objectives, agreeing on success criteria and then carefully analyzing different solutions against this criteria including performing a cost /benefit analysis,” Shapiro says. “Without proper project management and oversight, the implementation of a firm’s collateral strategy can diverge from the problem statement, resulting in sub-optimal processes, delays in go-live or in the worst case, no solution at all.”
Failing to provide a solution can be an expensive failing for a firm “and lead to frustration from the stakeholders as well as lead to a competitive disadvantage as the firm’s peer group moves ahead,” Shapiro says.
Even with perfect governance in place, firms have to be aware that there are many potential pitfalls, says Linden from Wilmington Trust.
Usually, the first major one is deciding whether to internally develop systems and processes or to outsource that effort — the classic buy or build decision. “It starts there. If you don’t have seasoned collateral [subject matter experts] with diverse backgrounds, you are likely to make some mistakes along the way,” Linden says.
In addition, when developing new systems or processes, “building to satisfy the bare minimum,” should be avoided, Cavallari says. The other extreme of going too far or “boiling the ocean” can also sink a project. “Significant gains can be made by satisfying what works in 80 percent of the collateral movement of one organization,” she adds.
Living with significant gains amid continuing uncertainty may be the new normal as emerging technologies such as blockchain/distributed ledger technology (DLT) represent major variables, Bandman says. In fact, “the technology picture is not sufficiently clear to implement a full strategic program of change,” Bandman argues.
“Collateral management is particularly susceptible to enormous benefits of efficiency from blockchain because every minute step of collateral operations is rife with reconciliations and different ledgers — all of which must be harmonized to the penny,” Bandman says. “But these [emerging] technologies are not yet ready for adoption in scale. Implementing a major technology program now risks the need for a do-over within three-to-five years when blockchain, I believe, will be ready for scalable, robust deployment in collateral management operations.”
While some emerging technologies may need more time to prove themselves, there may be some positive workflow changes that firms can expect when they overhaul their collateral management operations via established IT systems.
An IT overhaul will show firms “how to operationalize with technology a bespoke, manual process,” Linden says. “Too many ad-hoc, non-standard processes exist while technology and infrastructure players are meant for the standard 90 percent of the process,” he says.
Surh adds that “if firms can achieve enterprise-wide coverage of collateral management, they can recognize cost reductions by leveraging their existing infrastructure and reducing the manual touchpoints. This, combined with improved optimization can ultimately help firms better manage their capital and their balance sheet.”
Overall, the workflow changes for firms are “highly dependent upon individual firms and their legacy systems,” Cavallari says. “A firm may choose an off-the-shelf collateral management system and need significant integration.” Workflows are likely to be compressed because of regulatory-mandated timing requirements just as the volume of collateral movements “are increasing and scalability will be critical,” she adds.
Once a new strategy has been launched, how does an end-user firm know when it has successfully optimized its collateral management operations?
“I would focus on two metrics — compliance and funding optimization,” Bandman says. “The firm needs to know whether it has achieved both of these. The absence of a way to measure these is a strong indicator that they have not optimized the operations,” he adds.
“While the success criteria for the implementation of a collateral strategy will vary from firm to firm, in regards to the operations component, at a high level, firms can judge their success by viewing specific key performance indicators, which prove that they have implemented a scalable solution to meet their current and future needs,” Shapiro says. “Some examples of metrics that may be used can include number of aged disputes, average cost to process a margin call, and the number of margin calls processed per headcount.”
In the end, the effort to optimize collateral management operations “can be a real game changer. It can transform the treasury group from being a cost center to a group that provides operational alpha; that is, it can free up capital for the revenue generators in the front office,” Surh says.
For Cavallari at Russell Investments, a sure sign that a new collateral management strategy is working is fairly straightforward: “When there are few exception reports.”