Lombard Risk whitepaper series - Collateral management: Repo and securities lending

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1 Lombard Risk whitepaper series - Collateral management: Repo and securities lending August 2012

2 This whitepaper is confidential and may not be reproduced without prior permission from Lombard Risk. Contact Table of contents 1. Introduction The formation and expansion of collateral management in investment banking Regulatory reform and collateral management Margin operations and processes in the securities lending and repo markets... 6 a. Documentation standards 6 b. Trade eligibilities 6 c. Workflow 6 d. Calculation schedules 7 e. Pricing and trade valuation 7 f. Disputes 7 g. Client reporting 7 h. Internal reporting 8 5. Contemporary issues facing established markets and technologies Cross-product market initiatives and solutions in collateral management a. Data integrity 10 b. Technology 10 c. Cost and efficiency Author About Lombard Risk... 12

3 1. Introduction On 17th July 2012, Lombard Risk held an online business seminar entitled Collateral management: Repo and securities lending. The seminar tracked the formation and expansion of collateral management in investment banking since the late 1990s, current practice, contemporary issues, drivers for change and current market initiatives. This whitepaper provides readers with insight into repo and securities lending in the global collateral management marketplace. A recording of the webinar is available to valid business contacts register your details on our website at:

4 2. The formation and expansion of collateral management in investment banking The sudden and intense focus on the requirement to cover counterparty credit risk in the late 1990s spawned technological and operational solutions still evident in Repo and Securities Lending margin practice today. The Russian MinFin and Long Term Capital Management crises of the late 1990s sparked the financial industry s first hard look at collateral management practice. Market participants began to realise that exposures were inadequately covered. Systems were designed to automate collateral management calculations and processes; either built and supported in-house or via early vendor margin platforms. These offered simple but effective support, though with limited functional flexibility. Margin terms captured in collateral agreements at the time were often scant, resulting in bilateral margin call agreements developed on the basis of precedent and the limitations of participants IT systems. This led to a variety of margin calculations and processes that available technology simply could not support. Manual intervention and adjustment became commonplace. And as most participants supported repo and securities lending margin operations on different technology platforms, standards became increasingly diverse, despite broad similarities in products. As daily margining became standard practice in the repo and securities lending markets, the OTC derivatives markets were expanding rapidly, with an unprecedented volume and variety of exotic instruments being traded and requiring collateralisation. The form and complexity of these instruments, coupled with the comparatively detailed and precise margin terms held within the Credit Support Annex of ISDA documentation, demanded sophisticated technology solutions. Complex workflow-based margin systems emerged to support OTC margin operations, but were not consistently replicated in the repo and securities lending markets. Following the 2008 financial crisis and resultant collapse of Lehman Brothers, regulators focused intently on OTC markets where portfolios and exposures were large and difficult to unravel. Firms duly responded by improving the efficacy and efficiency of their operations. In comparison, secured repo and securities lending portfolios were relatively easy to close out or further secure through the adoption of prudent pricing or haircut strategies. Regulatory scrutiny, and with it the drive to develop and improve margin technologies, was limited in comparison.

5 3. Regulatory reform and collateral management Today, regulators are increasingly looking at collateral management policy and practice as a means of controlling and reducing market and counterparty risk, and of reducing the likelihood of bank default. Recent rule-making means financial institutions will be obliged to source and provide more collateral of a higher quality under both bilateral and central clearing agreements. Estimates suggest that additional global liquidity requirements under Basel III will reach 2.89 trillion, while Dodd Frank and EMIR legislation and global equivalents will further increase capital requirements. As a result, a global squeeze on the availability and cost of collateral is anticipated, putting intense pressure on firms to source and exploit collateral more cost-effectively. In response, firms are now seeking greater operational efficiencies in their margin programmes and optimal collateral inventory performance. The requirement for increased levels of higher quality collateral is likely to increase the volume of repo and securities lending activity among existing market participants, plus drive an influx of new entrants as firms seek to maximise their use of available collateral or source collateral that would not have been required pre-regulatory reform. Firms that are unable to satisfy their clearing collateral requirements directly from their proprietary inventory will have two options: Utilise the collateral transformation services provided by the direct clearing members of clearing houses with the associated cost; or Access the repo market directly as a relatively cheap and secure source of collateral More regulatory change is in store for the repo and securities lending markets. The FSB is due to publish proposals during 2012, although it is not yet clear what form proposed changes are likely to take.

6 4. Margin operations and processes in the securities lending and repo markets a. Documentation standards Repo and securities lending portfolios are supported under separate and distinct documentation terms. Exposures cannot at present be netted. Margin terms in repo documentation (GMRA) that define operational processes are limited in comparison with GMSLA and ISDA terms, although this is changing with the publication of the European Repo Council s Revised Operational Guidelines for Repo Margin this year. The Council are likely to provide recommendations including trade coverage, minimum transfer amounts and call schedules. Standard repo margin terms are bilateral, frequently based on precedence and with space for negotiation; the GMRA does not commonly support the imposition of terms by one party. The unintended consequence of this is a variety of bilaterally agreed operational processes which repo systems have struggled to capture and support both operationally and in terms of flexible exposure calculation. In contrast, securities lending documentation standards (GMSLA, OSLA, GESLA, MEFISLA) have tended to contain more detail, with terms defined and imposed by the lender, including trade eligibilities, call and settlement schedules, collateral eligibilities, concentration/correlation limits and pricing terms. GMSLA agreement terms tend to be more standardised, following a general lender is king principle. Nevertheless, terms can be complex and may include (or exclude) trades based on margin type, prepay and settlement status. Further, multiple margin events or movements may be made during the course of one day. Technology solutions have struggled to support the full range and complexity of these terms and processes. b. Trade eligibilities GMRA documentation currently lacks a standard definition of the rules relating to the inclusion of trades for exposure calculation purposes (although European Repo Council recommendations due this year are likely to address this). Discrepancies in market participants inclusion/exclusion of trades for margin call calculation purposes, according to start/end dates and settlement status, are commonplace. Again, technology solutions have lacked the flexibility to support these operational variations. c. Workflow Repo margin calls tend to be made on a net basis, and settled either with free cash or securities collateral. Repricing is also standard practice and supported in front office or within the collateral team. Operationally cumbersome, this process involves physically closing and re-opening each transaction, with exposure covered by the physical settlement of trade cash rather than the movement of free collateral. There is a tendency towards attempting to apportion margin calls within a net portfolio according to asset type or trading desk, though very few firms are able to support such a process operationally or technically.

7 There is a peculiarity in securities lending margining practice, where in almost all cases fixed income trading and equities trading under the same master agreement will be margined separately. This is in large part due to technical capacity and the fact that most firms use different margin platforms for each business line. In addition, it is common for the equity margin call to be covered in multiple parts. For example, a large and mixed portfolio may involve moving collateral across cash pools, marking rebate trades and moving free of payment securities resulting in four or five different margin movements all on the same day. d. Calculation schedules In the repo markets, the margin process tends to take place on an overnight basis. Technology platforms generally support close-of-business trade capture and pricing. As a result, firms encounter difficulties when attempting to recalculate exposure and agree margin calls on an intraday basis, in particular under stressed market situations. In contrast, in securities lending markets, intraday margining is common. Calculations are revised dynamically as the status of loan settlements is updated. e. Pricing and trade valuation Prices used for mark-to-market trade valuation purposes are usually agreed between parties in the repo markets. In the event of a dispute, general practice is to revert to front office to agree bilaterally which price should be used. Global variations in calculation methodologies are common, leading to multiple adjustment processes to agree margin call exposures. Intraday recalculations are usually not available as firms mostly operate close-of-business systems. Securities lending calculation methodologies are driven by technical capabilities. Intraday recalculation is commonplace, but the ability to support multiple methodologies or prices on a single system is still rare. f. Disputes Compared with the OTC derivatives market, disputes in the repo and securities lending markets are easy to resolve. Portfolios are comparatively small, trades can easily be proven to have either physically settled or failed, and prices are generally readily available for liquid securities. Portfolio reconciliation platforms are available to aid dispute resolution in the securities lending markets, however tend to be vendor or internally supported solutions and separate from margin platforms. Repo reconciliation, and the reconciliation of collateral positions, is still largely supported manually. The most efficient and controlled operational process is to embed trade and collateral reconciliation into the dispute process on the same technology platform as the margin workflow. g. Client reporting Bespoke client reporting is limited on standard repo and securities lending platforms. Client reporting tends to be carried out manually or achieved through an additional reporting integration layer which can retrieve and transform the necessary data from the margin systems into the required formats. The optimal process is to produce client-driven reporting in flexible formats, on an ad-hoc (real-time) or scheduled basis, direct from the margin system.

8 h. Internal reporting Particularly in the case of medium to large participants, internal reporting is generally constrained by the fact that data is held and produced in product silos. Firms trading and collateral platforms and the data flowing from them tend to be separate. As a result, consolidating data and gaining a cross-product view can be an enormous task.

9 5. Contemporary issues facing established markets and technologies At the GSF summit in Luxembourg earlier this year, delegates were polled on their primary financing concerns. More than 80% of respondents cited either collateral or operational risk. Other poll results from the summit similarly reflect firms preoccupation with technological hurdles. When asked which internal inefficiencies had the biggest impact on managing collateral, inability to manage collateral centrally or incomplete view over collateral balances comprised 39% of responses. Process automation and calculation and pricing flexibility are particular areas of concern. Booking controls should be automatically embedded into technology workflows to support the validation of collateral eligibilities, concentration limits and sufficiency checks. Margin systems should prevent the booking of ineligible collateral, and where possible assist in the identification of the most appropriate/optimal collateral. Dynamic exposure calculations should be enabled via real-time hook-ups to upstream and downstream data sources. Automated statements and reconciliations should be supported, reducing the need for third party external solutions. Firms need the technological flexibility to support the wide variety of margin methodologies employed globally without manual intervention, and the ability to re-run calculations on an anytime basis, especially in market stress scenarios. There is a growing need to forecast exposures, and simulate what-if scenarios to enable and maximise efficient collateral inventory management. Product silos need to be broken down. While products and collateral inventories continue to be managed across different technology platforms it remains difficult to gain an holistic, crossproduct view of risk, to optimise firm-wide collateral inventories, or to provide the consolidated and bespoke reporting that clients demand. As a result of all of these issues, many firms are reviewing both the efficiency of their collateral programmes and the capacity of their margin technologies to support their growing business needs.

10 6. Cross-product market initiatives and solutions in collateral management a. Data integrity Firms need to prove and improve data integrity and operational control by carrying out transaction reporting and reconciliation on a global basis. Proactive data sharing and automated portfolio reconciliation will assist in this respect, as will gaining global buy-in to improve the quality of dispute resolution techniques, for example the ISDA dispute protocol initiative. b. Technology Improving the efficiency with which collateral is managed is proving a challenging task. One of the biggest headaches endured by companies is IT complexity in the form of product silos, multiple systems and data sources and lack of technical integration. Significant initiatives in this space include the move towards single-platform, cross-product margin systems and electronic messaging. c. Cost and efficiency Pressures on collateral availability and cost are driving a focus on operational efficiencies and cost reductions within the collateral management programmes of many firms. They can achieve this in a number of ways, for example by sourcing collateral more effectively and streamlining their operational processes. The introduction of exception-based processing is a useful step, as is the use of a single, cross-product margin call and consolidated reporting. The answer? Financial institutions should remove the technological barriers between product silos that prevent them from gaining a clear view of their collateral management activities. Salvation potentially lies in the introduction Lombard Risk s single system platform, capable of supporting all a company s margined products, providing a consolidated view of a firm s collateral inventory and so enabling the optimisation of collateral across all margin agreements. The netting of margin requirements also then becomes possible, either from a reporting or a physical settlement perspective. And finally, client reporting can be consolidated, providing the company and its client with a view of the whole of their real exposure, across all products, to any given counterparty.

11 7. Author Elaine MacAllan Business Matter Expert Collateral management Repo and securities lending, Lombard Risk Elaine spent 13 years at Credit Suisse managing collateral operations across most products, specialising in repo and fixed income securities lending. She joined Lombard Risk 18 months ago to head up the design and development of the repo and securities lending module of COLLINE. Read more about the Lombard Risk COLLINE collateral management solution online:

12 8. About Lombard Risk (London Stock Exchange: LRM) Lombard Risk enables firms in the financial industry significantly to improve their approach to managing the risk in their businesses. Founded in 1989 and headquartered in London, Lombard Risk has offices in Cape Town, Hong Kong, Luxemburg, Mumbai, New York and New Jersey, Shanghai, Singapore and Tokyo. Our clients include banking businesses - 30 of the world's "Top 50" financial institutions - almost half of the banks operating in the UK, as well as investment firms, asset managers, hedge funds, fund administrators and large corporations worldwide. The Lombard Risk solution suite is developed and supported by an extensive team of risk and financial experts and includes: COLLINE - collateral management and clearing. A state-of-the-art, web-based solution designed by experienced business practioners for end-to-end, cross-product (OTC derivatives, Repos and Securities Lending) collateral management. It provides a consolidated solution for mitigating credit risk while satisfying the growing demand for multiple global entities, cross-product margining, Central Counterparty Clearing (CCP), optimisation, master netting, MIS reporting and electronic messaging. REPORTER - global regulatory reporting. A fully scalable solution for regulatory compliance at branch and/or head office level with global coverage. Fully supports key supervisory computations and integrates with LISA for stress testing and scenario analysis now part of the regulatory scene. Powerful and streamlined integration to multiple source systems enabled by the ETL functionality. Lombard Risk s REPORTER solution is the regulatory reporting market leader in the United Kingdom, supporting 130 out of 360 banks as clients. REPORTER also holds a significant market share in many countries in Asia and Europe. REG-Reporter - U.S. and Canadian regulatory reporting. A regulatory solution addressing financial reporting requirements by automating compliance with the mandated reports to all U.S. regulatory agencies and the Office for the Superintendent of Financial Institutions Canada (OSFI). Outside of simple spreadsheet solutions offered, there is no other vendor in America that services as many financial institutions as Lombard Risk does with REG-Reporter. LISA - scenario analysis and stress testing. LISA satisfies the latest liquidity risk management requirements and supports growing regulatory demands for timely and reliable information. Currently in use at many financial institutions in UK to meet FSA s 2010 liquidity regime. MIS Reporting - a flexible and easy-to-use module for reporting across the Lombard Risk product range AND with external sources. Provides valuable business intelligence by combining risk and regulatory information in reports or on-screen dashboards, enabling wellinformed business decisions to be made with confidence. REFORM real-time transaction monitoring and reporting - appropriate for Dodd-Frank Title VII/EMIR and similar regulations. The Lombard Risk software solution suite also includes OBERON trade capture and valuation and FIRMAMENT credit and equity valuation.