A holistic collateral model is now an essential development

With the ever-increasing importance of collateral from a trading, risk and capital management perspective, Nick Nicholls (Principal Consultant, GFT) argues that holistic management of collateral is rapidly becoming a necessity.

The process changes

The process changes needed to support holistic collateral optimisation and management will directly impact the organisational structure, systems infrastructure, trading and pricing practices of sell-side institutions.

For investment banks who aim high, the prize of full optimisation requires closely aligned collateral, financing and trading areas within an organisation. Some firms however, have yet to experience this epiphany and are instead focusing on compliance and continued operational stability, rather than efficiency and business opportunity. Firms should also urgently begin implementing the process and infrastructure changes required to achieve this end, as well as the challenges.

The challenge of achieving full optimisation will not be easy to overcome for firms. Breaking through divisional silos to facilitate best practise management of collateral, liquidity and funding remains difficult. However, we believe firms should set their ambition levels as high as possible. In doing so, the benefits of implementing a holistic collateral optimisation model will allow firms to positively thrive over the next five years.

The regulatory challenge

The International Swaps and Derivatives Association’s (ISDA) 2014 Margin Survey states that “Optimisation refers to the ability to post and re-use collateral according to delivery preferences such as the cost of funding and delivery, liquidity and market capitalisation, embedded haircuts in the Credit Support Annex (CSA), availability of assets to the delivery party, cost of reinvestment and yield, ability to re-use and risk”.

The introduction of Basel III has seen many banks struggling to deal with liquidity and capital requirements, emphasising the need to make improvements in their management of collateral.

If dealing with more demanding liquidity and capital requirements was difficult enough for banks, the challenge becomes even greater with the full introduction by 2018 of the Basel III leverage ratio which will have a huge impact on collateral flow and management within investment banks.

To mitigate counterparty credit risk (CCR) is the defining purpose of collateral. The way in which firms manage collateral whilst fulfilling the need for CCR mitigation varies greatly. The cost / price of transactions is driven by considerations such as risk weighted asset (RWA) impact (for margined and non-margined exposures). The ability to assess per transaction cost is difficult enough; being able to optimise and tune client transaction costs raises the challenge to a whole new level. For most banks this remains an elusive aspiration.

The holistic approach

Collateral optimisation is a core requirement, however, it is impossible to meet without undertaking other changes in the process, which in turn provide greater efficiencies front-to-back. Ultimately, this requires a reorganisation of a firm’s business model. ‘Full Optimisation’ examines the demand of the bank on its use of capital and liquidity, and aims to utilise asset pools based on a ‘best price’ basis whilst creating operational capacity to cope with that business demand.

In order to assess the robustness of a full collateral optimisation model, we need to analyse a number of key individual elements, that help facilitate efficient collateral management:

  • Electronically codified legal agreements which allow better data management
  • Economic decision making
  • Process and exposure management and control.
  • The use of ‘what-if’ pre-trade pricing, inclusive of collateral costs before any process
  • The transfer of costs / benefits back to the trader at the transaction level, with transparency on how those costs were borne and distributed

The objective should be to create a holistic model for collateral, with centralised funding and management. In such a model the ownership of the various parts of the collateral process remains clear and separate but interdependent, within one central funding function which includes inventory management under a trading function.

Doing nothing is not an option. More onerous capital and collateralised trading demands, require firms to examine how they can change their collateral processes if they want to remain competitive. Firms that get this right can approach the future with confidence, knowing that their collateral model will be ideally placed to cope with the increasing regulatory demands that now define the banking sector.

Those that don’t, risk being left by the wayside by those who have delivered a substantial collateral model. A holistic one is now essential.

A version of this blog post also appeared on Finextra.

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