The current pace of regulatory change can seem overwhelming to many buyside firms trading Derivatives. The move to central clearing of some OTC products has raised a number of new challenges around the collateral management process that buyside firms must deal with.
Regardless of whether you see opportunities or challenges in this changing landscape, proactive collateral management and optimization will be a competitive differentiator, a method of reducing costs and minimizing performance drag. Institutions that take an active approach and see collateral management as a core competency will outperform those taking a more passive stance.
Challenges for Buyside Firms:
Meeting New Collateral Demand
At this early stage, the data suggests that there will be sufficient collateral in the market in the coming years. However, the main challenge lies in creating a market infrastructure that gets the right collateral to the right place at the right time – a highly complex task.
It is important to think of collateral management as a tool for risk mitigation rather than an operational burden or a cost to optimize. In the situation of a counterparty default or market crisis, the collateral system must provide:
- a clear view of all margin calls and pledges to all CCPs and bilateral counterparties in one place
- visibility of allocated and unencumbered collateral across all funds: own, outsourced & third party
Delivering all of this while minimizing headcount costs and performance drag by allocating cheapest to deliver (eligible) assets, and by using collateral transformation services efficiently, gives some idea of the challenges ahead.
New Collateral Function and Processes
As collateral demands grow in the post-crisis landscape, funds may no longer hold enough cash to meet the increase in margin requirements. This will result in a drive towards non-cash collateral to reduce the impact on fund performance. Non-cash collateral requires more intensive processing, leading to a step change in complexity for the buyside.
Selecting Your CCPs and Clearing Brokers/FCMs
Settling on the most appropriate central counterparties (CCPs), clearing brokers and futures commission merchants (FCMs) can be one of the most time-consuming aspects of moving to a cleared environment. This increased complexity results in more margin calls, and more widely dispersed collateral (thus reducing concentration risk), but at the expense of increased operational risk.
These are only some of the evolving challenges that the buyside must overcome while keeping control of headcount, minimizing fixed cost increases, and reducing the impact on fund performance.
Solutions for Buyside Firms:
Reduce Derivatives Trading or Move to the Futures Markets
There may come a time when the accumulated costs of trading derivatives will increase to a point that eliminates the economic benefits of hedging, particularly for smaller buyside firms. Increasingly bespoke and complex derivatives trades that cannot be cleared may prove very expensive. Dealers will incur high capital charges for illiquid bilateral trades, potentially outweighing the benefits of these hedging tools.
Outsource Collateral Management
Business process outsourcing, a favored solution, allows the service provider to manage the operational processes involved in the collateral lifecycle. Thanks to the newly developing market infrastructure, there is no shortage of providers looking to offer value-added services such as collateral management and optimization.
Manage Collateral In-House
Alternatively, managing collateral in-house means investing in the technology, staff, and expertise to control the margining process. It allows full control over collateral usage and can utilize state-of-the-art technology systems that are customized to the firm’s business model. As long as the appropriate infrastructure is in place within the firm, performing some aspects of collateral management in-house can offer significant cost savings and avoid dependency on outsourced service providers. While successful collateral management is an operational hurdle, requiring investment in resources and technology, it is also becoming a core competency for buyside firms. It therefore makes sense for many firms to manage this in-house to some degree.
The optimum solution is almost always a combination of business process outsourcing and internal management, but the balance of the two varies from firm to firm. The due diligence process of any outsourcing must be rigorous and detailed to ensure that the service provider manages the client’s collateral in line with its risk guidelines and avoids any misunderstanding. However, as in-house expertise is unlikely to have kept pace with industry developments, the use of an external service provider is a necessity for growing firms. A collaborative outsourcing, or co-sourcing approach, enables firms to benefit from the cost savings and increased efficiencies associated with a near-shore provider, while ensuring that responsibility for risk management is kept in-house.
Effective collateral management represents a way to comply with new rules, reduce costs, and maintain returns for investors, while managing risk in line with boardroom expectations. Where you begin depends on your current level of sophistication, the likely impact of new regulations on your individual business model, and what the key drivers are for managing collateral within your firm. It is also important to consider where you sit on the curve of ‘cost avoidance’ versus ‘risk reduction’, since ultimately you need to be comfortable and confident operating in the new collateral landscape.
With the heightened pace of regulatory change, the new normal for the buyside community embraces the move from pure cost avoidance to risk mitigation. By enacting change now, firms will still be able to avoid onboarding bottlenecks, hit compliance dates with minimal disruption to business, and remain competitive in the new, more demanding operating environment.
Interested in reading more? You can download the full Buyside Collateral Management white paper, created by Rule Financial (recently acquired by GFT) and 4Sight here: Whitepaper.