This background paper, co-written by The Field Effect and BNY Mellon, is the first in a series of papers which will focus on the wide ranging collateral management challenges and opportunities currently facing the market.
We (The Field Effect and BNY Mellon) believe the series to be essential reading for asset managers, pension funds, insurance companies, banks and broker-dealers, as it will translate complex regulatory and market structure changes into straightforward operational imperatives.
It is widely acknowledged that ongoing changes to collateral supply and demand dynamics are challenging even the most sophisticated and experienced organizations, with many firms (both financial intermediaries and asset owners) struggling to grasp the full implications and potential opportunities of the new landscape. The reformation and restructuring of the financial markets in the aftermath of the global financial crisis has had a profound effect on how collateral is used and managed. Nevertheless, it is worth emphasizing one key point: we believe these events can ultimately have a positive impact on firms that use collateral to support their funding or investing strategies.
This Paper examines the development of collateral management and identifies the key issues of the current collateral landscape, including the anticipated difficulties in accessing supply. Subsequent papers in this series will focus on complex regulatory challenges and innovative solutions. By looking at the current fragmented collateral landscape and the response of infrastructure and service providers, we tackle key issues, such as:
At a summary level, key issues can be identified as:
We are witnessing a realization that now is the time for significant change. This task should not be underestimated and many firms may not fully appreciate the challenges they face, nor recognize the opportunities available in the market. We believe collateral management will evolve from being primarily a process of managing assets for margin purposes, to a position where much greater consideration is required to manage assets from a collateral value, cost and balance sheet perspective.
As the sophistication of collateral services evolves, we will see increasing levels of innovation from service providers who truly understand their clients’ needs and have the vision to develop services to support them. A critical part of the collateral challenge will be for firms to select the service elements they require and identify the service provider that can most effectively meet their needs in the long term.
Collateral management has become a sophisticated discipline with financial institutions often making collateral management a dedicated role. A presumed abundance of liquidity and leverage in the period prior to 2008 meant collateral management processes were often fragmented, imprecise and imperfect in practice. The events of the global financial crisis exposed some products and institutions in financial markets as severely under-collateralized, while other financial markets dried up due to a sudden absence of either trust or collateral. The regulatory response to the crisis has increased the activities and transactions for which collateral is required, as well as leading to demand for higher quality collateral. As a result, collateral management has become a much more urgent, business-critical concern for a much wider range of institutions active in the global securities and derivatives markets, encompassing banks, brokers, investment managers, hedge funds, pension funds, insurance firms and other asset owners. To a lesser extent, multinational corporations will also be drawn further into the collateral world, both due to their use of OTC derivatives and as providers of cash via the repo markets, where they will look to balance yield with security, taking secured exposure over unsecured Bank deposits.
This section examines the practice of collateral management before, during and since the financial crisis, highlighting the key requirements for effective collateral management in an emerging post-crisis environment in which demand could well outstrip supply.
The post-crisis reforms have had a substantial impact on both the users and providers of collateral, as well as on those they rely to manage collateral effectively: service providers (such as custodians) and market infrastructure operators (primarily CSDs and CCPs). Whilst the regulators have generally maintained a commercially neutral stance, allowing the market to define business terms, rates and definition, they have also encouraged competition, notably among CCPs. The evolving regulatory framework has not only changed business and operating models; it has also called into being new structures and facilities. However, the long-term viability of some service providers may come into question as costs, returns and compliance pressures start to bite. In this section, we review the role of service providers and market infrastructure operators in the new collateral environment and some of the challenges they face.
A tri-party transaction is one in which all post-trade processing, i.e. collateral selection, payment and settlement, custody and management, is outsourced by the transacting parties to a third party, known as a tri-party agent. The TPA acts on behalf of both parties, identifying a sufficient value of eligible collateral and initiating delivery from provider to receiver. Securities selection is normally made in accordance with a pre-agreed algorithm.
Established in the repo and securities lending markets, the operational advantages of tri-party transactions are being transferred to other markets, specifically the automatic selection and movement of eligible collateral. Once an exposure has been confirmed, the TPA is notified of the instruction fields (i.e. required collateral value, settlement date, eligibility set and counterparty / CCP) and the movement of collateral will occur.
Tri-party collateral management services (TCMS) cover a range of functionalities, such as recalling (substituting) collateral delivered in the event of a pending corporate action, which can be combined to offer tailored collateral optimization solutions. TPAs can also monitor for the sale of any inventory being used as collateral, in which case the TPA will automatically recall securities, and substitute alternative collateral held within the inventory. TCMS are governed by a tri-party service agreement that sets out the services to be provided to support the underlying bilateral agreements (e.g. GMRA, GMSLA, ISDA CSA/CSD, etc.). The expected growth in collateral movements – in response to increasing margining requirements for derivatives transactions – is likely to prompt market participants to turn to TPAs to support the automation of their collateral selection process, to initiate the securities movement and to carry out post-delivery substitutions.
Tri-party services are typically provided by global custodians or international CSDs. BNY Mellon has been a key tri-party collateral management service provider over many decades and continues to develop its services to support clients’ increasingly complex collateral needs. As of end-Q1 2015, the average total global tri-party collateral balances managed by BNY Mellon daily stood at US$2.2 trillion, based on a mixture of repo, securities lending, clearing-related collateral management and OTC derivative exposures.
Usage levels of TPAs differs markedly across the U.S. and European repo markets, with TPAs used to settle the vast majority of US$ repos, compared with around 10-12% in Europe. (BNY Mellon manages over $2.2 trillion of collateral by value across a range of Triparty Collateral Management activities in the U.S., EMEA and APAC regions).
The U.S. Tri-Party Repo Infrastructure Reform Task Force developed and implemented solutions to reduce systemic risk, practically eliminating intraday credit risk and enabling market participants to continue to efficiently and effectively fund their operations. Working with market partners, BNY Mellon has played a major role in the design and implementation of the risk reduction initiatives that have been implemented through a series of operational and technology changes and improvements.
The 2008 financial crisis resulted in a large number of regulatory and market structure changes directly impacting the collateral world. There is a market hierarchy of collateral sophistication, with perhaps a firm’s focus on collateral seemingly proportionate to their reliance on collateral for the firm’s activities. Certain firms have developed highly sophisticated collateral solutions, for example if they depend on the use of collateral for funding. Other firms may be less reliant on collateral for funding, and as a result have simpler collateral solutions. Our view is that both approaches to capital may have to change.
The immediate focus for firms will be on the need to adjust their collateral operations and strategies so that they can operate effectively in the evolving post-crisis market environment, which continues to be reshaped by a regulatory calendar that currently extends beyond 2017. Practically, this means firms must be operationally capable of ensuring there is sufficient collateral available, at the right time, in order to meet margining and other requirements. These increased collateral obligations and practices could include:
Today, for all firms, there is a recognizable market move away from the traditional decentralized product-focused approach to managing collateral toward a centralized (or enterprise-wide) collateral solution, with an increased focus on both global and cross-border activity. However, many firms continue to struggle to move away from their traditional practices based on asset classes, despite the ultimate benefits that can be achieved from centralization. As such, it is still too early to honestly claim a victory in this area as efforts are still a ‘work in progress’.
TFE is a boutique consultancy specializing in clearing and collateral management, spanning cleared and uncleared OTC Derivatives and Exchange Traded Derivatives.
We provide advisory services to every participant in the industry value chain including; buy-side and sell-side firms, clearing houses, custodians and CSDs.
TFE was founded and is led by David Field, an acknowledged expert in clearing and collateral management. With over 20 years financial services consulting experience, David has led many clearing and collateral advisory projects across buy-side, sell-side, CCPs and custodians, spanning strategy, target operating model, and technology. David speaks at numerous industry conferences and is frequently quoted in financial services media.