Collateral Management in the Front Office: How to turn risk mitigation into competitive advantage

Collateral Management in the Front Office: How to turn risk mitigation into competitive advantage White Paper

A NEW ERA IN COLLATERAL MANAGEMENT If you are a C-level executive in charge of your collateral management strategy, you will be facing enormous challenges and opportunities in this post financial crisis era. How do you respond to the increased focus on collateral management, optimize its use and gain a competitive advantage for your firm? This white paper explores the key capabilities that should be considered so you can turn risk mitigation into a profit centre. In today s business environment where capital is scarce and eligibility criteria for collateral are highly constrained, many firms are looking for help to transform their assets into usable securities. Also, new market paradigms such as the Credit Support Annex (CSA) discounting and Credit Valuation Adjustment (CVA) are paving the way for more accurate pricing of derivatives in the front office. These forces present enormous challenges to both the buy and sell-side in identifying and optimizing collateral assets. As a result, collateral management is taking centre stage and trading floors are transforming their collateral operations from a backstop for bilateral OTC derivatives deals to a central component in the pricing and risk management of these trades. However, to achieve their goals, organizations are discovering that a new era of enterprise collateral management framework is required. In this paper we are aiming to even go one step further: We will explore how with the right design risk mitigation can be turned into a profit centre. For organizations who are looking to optimize their collateral use, what will the key capabilities and considerations be to turn this investment into a competitive advantage? The recent financial crisis laid bare the dangers of counterparty credit risk and liquidity risk. The response of the authorities has been emphatic, with regulators across the globe embarking on a far-reaching rewrite of market rules. At the same time, the economic environment for financial institutions has worsened and business has become more difficult and competitive in many areas. One of the after-effects of these developments is a substantial change in the role of collateral. What was once a low-profile back office process has now become not only a compliance matter, but a trading and risk consideration, and even a competitive issue. With the introduction of central counterparty clearing in the over-the-counter (OTC) derivatives markets and the associated requirement to post initial margin, anticipating and pricing in the cost of collateral is now an integral part of deal making a front office function along with pricing and position keeping. But just as collateral is taking center stage, cash has become scarce and high quality liquid assets are now prized items that must be judiciously allocated. As a result, institutions can no longer afford a fragmented piecemeal approach to inventory management but must optimize their assets from a holistic enterprise perspective. To meet the challenge of enterprise collateral optimization, institutions need a solution that looks at collateral management across asset class silos and enables trade or margin calls to be initiated from a single system. This can be achieved with an enterprise collateral management (ECM) platform built on a resilient, high performance technology foundation that integrates easily with trading and risk systems to leverage existing functionality and avoid duplication of processes and the need for reconciliation. An effective ECM solution will allow the creation of new services such as collateral transformation and upgrade, and support the evolution of collateral management into a profit centre. 1 White Paper

Key drivers 1: NEW REGULATIONS Basel III and CVA increase collateralization In their response to the events of 2007-08, the regulators have sought to strengthen banks ability to withstand crises and periods of stress, and to reform those areas of the market seen to pose the most threat to stability. The Basel III framework proposed by the Bank for International Settlements addresses the capital adequacy of banks, while the US Dodd-Frank Act, the European Market Infrastructure Regulation (EMIR) and similar initiatives in other jurisdictions aim to improve transparency and oversight with the imposition of new standards and market practices. Basel III requires banks to hold more capital of a higher quality as a protection against potential credit losses. The level of risk-weighted assets, on which regulatory capital calculations are based, has been adjusted to more precisely reflect the risk of business exposures. The rules of what constitutes eligible capital have been tightened and minimum capital ratios have been raised, with new requirements for the liquidity of assets held as capital. Basel III also includes measures to improve the management of risk in banks, particularly counterparty credit risk. A new requirement to calculate a credit value adjustment (CVA) is a mechanism to quantify and manage credit risk and any deterioration of a counterparty s credit rating. Banks must set aside capital against their CVA and this must be taken into account when pricing and calculating the profit and loss of trades. The overall impact of these measures is a significant constraint on the capital available to banks for operating their business. The required CVA amount is diminished dramatically when trades are collateralized, particularly if the pace of margin calls is high. Dodd-Frank and EMIR set new margin requirements To improve market transparency and reduce counterparty credit risk in OTC derivatives, Dodd-Frank and EMIR are driving banks away from the world of customized bilateral agreements to an exchange-traded model, with standardized products, multi-participant execution venues and central counterparty clearing. Unlike the old bilateral OTC derivatives market, where most deals required participants to post only variation margin to cover the mark-tomarket adjustment of counterparty credit risk exposures, now all centrally cleared transactions additionally require initial margin to cover future potential exposures. Furthermore, central counterparty clearers (CCPs) are far more restrictive in what they will accept as eligible collateral, generally insisting on the highest rated assets, such as government bonds for initial margin and cash for variation margin. The introduction of central clearing for OTC derivatives divides deals into cleared and uncleared, limiting the netting potential across portfolios the traditional method for calculating collateral. The fragmentation of portfolios is exacerbated by the absence of regulatory restrictions on the number of CCPs that can serve a market, which is leading to multiple clearers across asset classes and regions. Since participants will not necessarily have control of where their transactions are cleared, they could find themselves having to pledge collateral at multiple venues, further undermining netting efficiencies and increasing collateral requirements. Dodd-Frank constrains collateral rehypothecation Under Dodd-Frank, buy-side counterparties can insist that the margin they pledge is held in a segregated account or by a third-party custodian. This means that dealers will no longer be able to rehypothecate this collateral for their own use as they have done in the past, further limiting available assets. $2.5 trillion of new collateral required The cumulative effect of these regulatory developments is to severely constrict the availability of capital and securities while creating an escalating demand for highly liquid unencumbered assets. Research firm Celent estimates that 40-50% of OTC derivatives contracts will be cleared by the end of 2013, generating a demand for $2.5 trillion worth of new collateral. Finding these assets will be a challenge. With cash scarce as a result of Basel III and harsher global economic conditions, institutions will need to identify all potential collateral, making greater use of the repo and stock lending markets to transform the securities they hold into more eligible liquid assets. And they will need to optimize the deployment of the collateral they gather so they can meet their margin calls in the most efficient manner. White Paper 2

Key drivers 2: changing processes, systems & cultures New approaches to pricing collateral To accurately calculate the present value of a derivative, expected cashflows must be discounted based on the collateral remuneration rate when the derivative is collateralized and on the treasury rate when it is not. Before 2007, the rates were considered roughly equal, with the treasury rate generally used for both collateralized and uncollateralized trades. However, following the bankruptcy of Lehman Brothers, the basis spread between the collateral rate (typically overnight rates) and the treasury rate (typically LIBOR) jumped and has not returned to its previous level. As a consequence, it is now essential to discount on collateral currency and remuneration rate when valuing collateralized trades. This method is known as CSA discounting. To be able to price accurately, traders and risk officers need tight integration between the collateral management framework and the trading, position keeping and risk management systems to compute the fair value of a deal. Breaking down silos The new regulatory and economic regime demands that institutions rethink their whole approach to collateral. Until recently, collateral management was a completely isolated back-office administrative process. Repo, securities lending and OTC derivatives collateral typically operated in separate silos, with sometimes further silos for individual OTC derivatives asset classes. Margin requirements were simpler, less frequent (typically once a month), and less onerous. In most cases, bilateral OTC derivatives trades only required variation margin to reflect mark-to-market profits and losses. The eligibility criteria for the collateral, set out in the Credit Support Annex (CSA) to ISDA Master Agreements, were generally more flexible than what is required for today s central clearing environment. Although many larger players have established collateral netting arrangements with significant counterparties, collateral management has remained a largely defensive policing function. This approach is no longer fit for purpose. With the demand for high quality liquid assets set to soar, institutions are going to have to break down their collateral silos and create an enterprise approach that will allow them to build a holistic view of their counterparty exposure, and optimize their cash and security inventory across their silos. It is no longer just the back office that needs to respond to margin calls and decide on what securities to pledge because the front and middle offices now want to have an active role in these decisions as they look to transform their assets into usable securities. The changing regulatory and market environment means institutions need to take a proactive enterprise approach to collateral management. Firms who are late to respond could be put at a serious competitive disadvantage, whilst those who have sized the initiative and made the right investment choices could transform collateral management from a back office cost centre into a front-line profit centre. 3 White Paper

Best practice in enterprise collateral We recommend that organizations implement a proactive profit-oriented approach to collateral management that calls for a holistic perspective on eligible assets and their means to maximise their use across business activities. This requires an enterprise platform that can access data on all margin commitments and collateral sources and provide traders and risk managers with the information they need to make optimal collateral decisions. By integrating with existing front and middle office systems, the Enterprise Collateral Management (ECM) platform can avoid redundancy of functionality, as well as the operational risks of re-implementing a data model and reconciling prices. Diagram 1: Collateral as the keystone RISK COLLATERAL BACK FRONT In the new era of collateral management, the collateral process is a keystone between the front office, risk management and back office functions. A collateral agreement is a contract in itself affecting the value of the trading book which needs to be incorporated in the front office. The ideal solution should also leverage already existing risk solutions to calculate risk based on initial margin requirement, and to strengthen integration throughout the STP chain in the back office. Integration with the front office The first step in the collateral optimization process is the calculation of margin commitment. The pricing of deals already takes place in the front office, so it makes sense to delegate the valuations on which the margins are based directly to the front office systems. This avoids the need to reconcile prices between systems. But the interaction between front office system and the ECM platform must be bi-directional, because the front office now also require information on eligible, pledged or received collateral, their currencies and remuneration rates, in order to reflect collateral accurately in the derivatives price. Integration with risk management Initial margin is not different from a market risk result, taking into account correlations between trades. Whether it uses a Value-at-Risk methodology or a set of stress tests, an institution that already has an enterprise risk system will want to leverage its existing capabilities and avoid the duplication of risk/margin functionality and reconciliation of calculations. Integration of the ECM platform with the enterprise risk system is also driven by the need for the risk system, when computing CVA, to have access to details in the collateral agreement the golden copy of which will reside in the ECM system. Integration with the back office Collateral management has historically been embedded in the back office, where tasks such as tracking assets, reconciling disputes and responding to corporate actions have been undertaken. However, the pace and complexity of collateral processing is increasing dramatically. What was once a weekly, or even a monthly, cycle has now become a daily routine, with the trend inexorably towards intra-day margin calls. The use of collateral limits needs to be monitored in a near real-time mode, triggering alerts to collateral managers, and followed centrally in the ECM platform. Satisfying this demand requires a robust, high performance back office platform with straightthrough processing, tightly integrated with the collateral monitoring and trading. This STP process has to cope with a multiplication of securities and cash accounts to manage account segregation, tri-party agreements, as well as collateralization by currency silos promoted by ISDA Standard CSA initiative. White Paper 4

Best practice in collateral optimization and inventory management Step 1: creating an enterprise view of inventory An ECM platform integrated with the front, middle and back office will be able to calculate and process net collateral requirements across all agreements. Similarly, the platform will have access to all the necessary data to create an enterprise view of the security inventory. Bonds may be located in one system, stocks in another, gold and precious metals elsewhere. The ECM platform will gather information on all eligible assets into a centralised securities inventory. The inventory should include any information relevant to compute the net security position, such as details of long or short positions, and whether they have been lent or borrowed, or sent or received as collateral. An inventory should give the balance as of today, but the expected flows and balance for coming days. Real settlement date, rather than simply theoretical date, is essential too to avoid pledging bonds that it may not yet have received information that can be obtained by leveraging the back office date information. Step 2: refining the inventory Not all assets will be eligible as collateral in all circumstances, so the securities inventory will need to be further refined. Inventory is first filtered by agreement, applying the eligibility criteria defined in the relevant CSA - either a set of rules based on factors such as security type, maturity, rating, etc. or an explicit sub-list of securities like the one published by the European Central Bank. A second filter can apply any relevant internal security availability policies. Diagram 2: An enterprise view of inventory Collateral transformation Collateral optimization Cross asset margining INVENTORY MANAGEMENT Compliance Repo trading Stock lending For example, the institution may want to place restrictions on pledging certain stocks or bonds that are earmarked for other purposes, like algorithmic trading. This refinement process will separate out the collateral that is properly eligible for the current margin requirements. Step 3: adding decision-making indicators Selecting the appropriate and available collateral requires examination of the assets associated static and market data, as well taking into account various contextual indicators. Static and market data includes maturity, next coupon date, sector, haircut, repo rate, market price and market liquidity (computed as the average of transactions made on the previous days). Contextual indicators include rehypothecation rate, concentration ratio and limits, and the marginal initial margin the effect on the initial margin of pledging a particular security. An indication of the true liquidity position of the collateral is also important to avoid long term liquidation of the collateral position in case of a default event. A wrong way risk indicator enables the identification of the correlation between a bond issuer and the collateral counterparty. Collateral managers also need to be able to add their own indicators on the fly, for instance to tag securities identified as special for limited or unlimited amounts of time. Step 4: optimization Given the carefully filtered inventory on eligible collateral and the comprehensive set of decisionmaking indicators, collateral managers will be able to overlay their current assessment of the market and knowledge of securities to optimize their use of available resources. In a fast moving or complex market, collateral managers can bring their experience and insight to bear on how best to deploy the available collateral to meet their margin requirements while maximizing the return on the securities. This optimization process could be automated by enabling users to capture their decision criteria as a set of rules and applying an optimization algorithm to compute the most efficient collateral allocation. Such an optimization process would typically rely on heuristic methods, taking into consideration all agreements and their respective constraints in order to identify cheapest-to-deliver collateral from the enterprise point of view, which may be different from collateral selected sequentially, agreement by agreement. To be efficient, the decision making tool used to optimize and allocate collateral needs to be able to initiate the relevant margin calls, rather than having to rely on separate decision-making and margin call initiation systems. Maintaining separate systems is more costly and can also introduce operational risk where data has to be re-input, aggregated or reconciled. 5 White Paper

Collateral as a competitive advantage By providing near real-time analysis of margin requirements and securities inventory, an ECM platform will enable firms to seize upon opportunities to optimize collateral. In addition, real-time reconciliation of margin calls will allow institutions to challenge counterparties immediately where there are discrepancies, ensuring any credit risks can be caught quickly. Real-time pricing and real-time risk will also enable institutions to anticipate margin calls, for both initial and variation margins, preventing them being caught out by unexpected liquidity requirements. Competitive advantage for sell and buy sides Cross-asset, high performance enterprise collateral management can provide swap dealers with a competitive advantage by enabling them to lower initial margin required from their counterparties, thereby attracting more business. This can be achieved without increasing risk, by taking advantage of the correlation between asset classes, and by being able to be alerted and make a call more quickly, intraday for instance, in the case of unexpected losses. Real-time initial margin capability will enable both sell and buy side firms to choose those contracts that have a lower cost of liquidity by enabling them to compute the marginal effect of a trade in pre-deal blotters. Providing collateral transformation and optimization services In today s business environment where capital is scarce and eligibility criteria for collateral are highly constrained, many firms are going to look for help to transform their assets into usable securities. A powerful and robust ECM platform will enable banks and brokers to offer collateral transformation and optimization services to their clients, leveraging the security inventory for security finance business. This will move collateral management from a defensive, back office role into a profit centre fit for today s markets. A solid technology foundation To achieve these goals, a real-time ECM platform must be built on strong technological foundations. Ease of integration An open architecture and APIs will allow the ECM platform to easily integrate with in-house and third-party trading and risk management systems, keeping additional costs low and providing a fast return on investment. This is key to leveraging existing front office pricing and middle office risk engines and avoiding redundant functionality as well as the operational risks of replicating data and multiplying processing facilities. Enterprise data fabric The data fabric approach, where data is held in memory rather than in a database, enables more efficient read-write operations, speeding up data processing and analysis without redundancy of data storage. Data management capabilities are required that will allow the ECM platform to gather all necessary information in an enterprise data fabric, with unlimited cache memory in order to scale and meet growing future requirements. In-built resilience and reliability will avoid outages and ensure maximum availability and business continuity at all times. Conclusion The financial crisis and its aftermath have created a new era in collateral management. Capital is at a premium, while new regulation is creating a huge demand for more high-quality liquid assets. In this environment, collateral management can no longer remain an afterthought to OTC derivatives trades, or an isolated process attached to repo and securities lending. It is time for collateral management to emerge from the back office and become an integrated real-time proactive function that not only meets today s more onerous margin requirements, but offers competitive advantage as well. Achieving this requires a robust high-performance ECM platform that leverages existing front and middle office functionality. Implemented successfully, an ECM optimization platform can help transform collateral management from a cost centre into a profit centre, and increase market share. White Paper 6

MISYS RECENT MARKET RECOGNITION NUMBER ONE TRADING SYSTEM TECHNOLOGY PROVIDER RISK TECHNOLOGY RANKINGS 2011 Number One Overall Trading System Number One Pricing and Analytics Equity Number One Pricing and Analytics Inflation STRUCTURED PRODUCTS TECHNOLOGY RANKINGS 2012 Number One Trading System Credit Number One Trading System Cross Asset Number One Trading System Foreign Exchange Number One Trading System Rates Number One Risk Management Collateral Management Christophe de La Bastide Product Manager for Enterprise Collateral About the White Paper s author Christophe de La Bastide is Product Manager for Enterprise NUMBER Collateral ONE RISK at Misys. MANAGEMENT He specializes in the strategic direction of Misys capital markets TECHNOLOGY PROVIDER solutions in the areas of asset class evolution and collateral ASIA RISK management. TECHNOLOGY In 2011, RANKINGS de La Bastide s 2011 role was expanded with the inception of Misys Number One Overall Risk Management enterprise collateral. Number One Trading System Equities He Number joined One Misys Trading 2008 System in the Foreign Sophis exchange area of the business, Number One developing Trading System strong Interest front rates office financial skills as a consultant in the security finance and delta one areas. He has worked with customers such as ABN-Fortis, HVB-UniCredit and Natixis, as well as on projects such as implementing solutions Number One Support services Implementation efficiency in the areas of commodity, equity and global security financing. He is graduated from Ecole Polytechnique in Paris. Christophe would value any feedback at christophe.delabastide@misys.com Number One Derivatives pricing and risk analytics Equities Number One Derivatives pricing and risk analytics Interest rates Number One Derivatives pricing and risk analytics Hybrids BEST TRADING PLATFORM BACK OFFICE ASIAN BANKER TECHNOLOGY AWARDS LEADING SINGLE TECHNOLOGY PLATFORM PORTFOLIO, TRADING AND RISK MANAGEMENT HEDGE FUND JOURNAL AWARDS 2011 STRUCTURED PRODUCTS TECHNOLOGY RANKINGS 2011 Number One Trading System Equities Number One Trading System Interest rates Number One Pricing and Analytics Equities BEST RISK MANAGEMENT INITIATIVE ASIA ASSET MANAGEMENT AWARDS ABOUT MISYS Misys is at the forefront of the financial software industry, providing the broadest portfolio of banking, treasury, trading and risk solutions available on the market. With 1,800 customers in 120 countries our team of domain experts and partners have an unparalleled ability to address industry requirements at both a global and local level. Misys was formed by the merger of Misys with Turaz, which includes the award-winning Kondor+ product line. Combined they are able to address all customer requirements across both the banking and trading book businesses. Misys is the trusted partner that financial services organisations turn to for help solving their most complex problems. Misys and the Misys globe mark are trade marks of the Misys group companies. Copyright 2012 Misys. All rights reserved. Find out more at www.misys.com 9440 / 1012