Many asset managers will have breathed a sigh of relief at the announcement in April from the Basel Committee on Banking Supervision and the International Organization of Securities Commissions that the fifth and sixth waves of the Initial Margin Rules (IMR) would be delayed by a year to September 2021 and September 2022. Under the rules, in-scope firms are required to post Initial Margin (IM) for all uncleared derivatives. Despite the delay, the indications are that most wave five firms are continuing their IMR preparations because firms already engaged in implementations are painfully aware of the operational and legal lift required to go live.
Aside from IMR, collateral was already in the spotlight for many firms. Market volatility in March saw margin call volumes running at almost double normal levels, which put many collateral teams under a severe test. For some, the volatility highlighted weaknesses in their core operational function of securing collateral to offset counterparty exposure. Meanwhile, front-office teams are increasingly focused on the need for collateral optimization, in particular for derivatives-heavy portfolios, to reduce collateral drag on returns.
The IMR delay has bought the industry time to address the challenges and deep-seated inefficiencies in the bilateral margining process that are progressively eroding investment returns.
The Opportunity Cost of Collateral
Asset managers handling collateral across multiple funds and custodians have traditionally prioritized operational simplicity over collateral funding efficiency, resulting in collateral strategies that hold a large slice of fund assets in cash to cover anticipated margin calls. “Every dollar posted as cash collateral or held as a buffer for potential daily margin swings incurs an opportunity cost of lost investment returns,” says Fergus Pery, EMEA Head of Collateral Management at Citi Securities Services. “The growing collateral drag on investment performance is like driving with the handbrake on.”
To combat this, firms are looking to use a number of tools such as improved operations and better use of technology. Firms are also investigating fundamental changes to how they run their collateral programs and how they can optimize their collateral.
Every dollar posted as cash collateral or held as a buffer for potential daily margin swings incurs an opportunity cost of lost investment returns.
Improve Collateral Efficiency with Operations
In March, collateral operations teams experienced a sustained period of high margin call activity that coincided with the introduction of COVID-19 lockdown controls, which forced most staff to work remotely. This combination of circumstances provided a severe test of the resilience of firms’ collateral management facilities. Many faced challenges in ramping up capacity to handle the increased levels of disputes and settlement fails, with the added obstacle of managing staff dispersed across multiple locations and struggling with remote-working communications. Additional complexities arose from credit rating downgrades that triggered changes in collateral obligations or eligibility and higher levels of substitution as collateral levels ramped up.
As firms look back on their recent experiences, the daily levels of uncollateralized exposure could provide ample evidence of the resilience, or otherwise of their operational platforms and their ability to ensure they are in the best possible position in the event of a counterparty default. Spikes in settlement fails or disputes often point to a lack of operational scalability in the core functions of the margin call agreement along with collateral selection and instruction. Firms can rapidly build capacity by automating linkages between their collateral platforms, counterparties, and custodians. “This connectivity can lead to the entire collateral process being executed without manual intervention,” notes Pery. “Firms with this level of automation are well placed to absorb capacity peaks with sufficient operations time remaining for exception management.”
Streamline Collateral Flows with Triparty
While struggling to streamline their bilateral margining processes, asset managers’ coming under the final IMR waves are also being exposed to the speed and efficiency of triparty collateral. Triparty collateral is when transacting parties jointly delegate collateral functions to a neutral party.
It’s the method almost universally used by the dealer community for pledging IM because it gives them the flexibility to deploy a wide range of securities, without the operational overhead associated with bilateral transactions. For example, firms pledging IM in triparty can freely trade over those assets knowing that the automated substitution process offered by triparty collateral service providers ensures pledged assets are returned to the trading account prior to settlement date.
Historically, the use of triparty collateral was not an option for firms holding their assets with a global custodian. However, recent developments in the triparty space, such as the Collateral Portfolio Service introduced by Euroclear, have overcome this hurdle. Firms can now benefit from the full flexibility of triparty collateral automation to pledge collateral while maintaining their inventory at their existing global custody accounts. In-flight IMR projects give these firms the perfect opportunity to adopt these new capabilities and get their collateral flowing faster.
“Firms have growing needs to access liquidity in order to support their derivatives margining activities but many wish to avoid the cost and complexity of full participation in the repo markets.”
Optimize Collateral with Transformation
To mitigate the drag associated with holding cash collateral, firms have considered using securities as collateral. Historically, there have been two obstacles to this approach. The first is resistance from counterparties to accept securities as eligible collateral. The second is the growing proportion of derivative trades that are cleared, for which only cash is acceptable for the required variation margin. Nonetheless, it doesn’t have to be this way. Firms can put their assets to work, limit initial margin obligations, and make full use of efficient funding sources to minimize or eliminate the drag resulting from margining in cash.
Funding capabilities can be quickly enhanced by outsourcing securities financing, such as repurchase agreements (repo) on an agency basis, which is already widely practiced for stock lending. “Firms have growing needs to access liquidity in order to support their derivatives margining activities,” says David Martocci, Head of Agency Lending at Citi Securities Services. “But many wish to avoid the cost and complexity of full participation in the repo markets.” Leveraging an outsourced provider can give firms a scalable way to optimize collateral, without having to invest in building the capabilities in-house, and ensuring best execution.
Rather than be driven by operational considerations alone, a high level of automation should equip firms with the flexibility to deploy cash, securities, and received collateral based on the most efficient funding strategies. Finally, adopting collateral analytics tools can help firms balance collateral coverage with funding efficiency to accurately assess the optimal funding strategies for each portfolio under changing conditions.
Making Collateral a Competitive Advantage
As the COVID-19 experience demonstrated, collateral is more important than ever during a crisis. It creates intense focus on the operation, economics, and objectives of the collateral management function. Equipping collateral teams across the front office, treasury, and back office with the tools and transparency to manage this combined collateral and liquidity challenge looks set to become a key area of competitive differentiation.
Firms have the opportunity afforded by the regulatory delay to direct this focus to reinforcing their collateral capabilities, both to create the operational capacity to weather the current storms and, more strategically, to lay the foundations of a more efficient collateral and liquidity model which will better support the needs of their investors in the long term
How to Reduce Collateral Drag
Asset managers should consider the following techniques to help reduce their collateral drag.
- Review and test the new infrastructure to discover any weaknesses where trade flow mistakes could occur
- Enhance your connectivity to custodians, margin hubs, and portfolio reconciliation services
- Investigate the suitability of a triparty solution for your collateral needs
- Work with triparty provider to get the necessary documentation, accounts, and workflows in place
- Assess your portfolio of securities that are eligible for transformation
- Partner with a third-party securities financing agent to establish parameters for collateral transformation program