Collateral management has become a hot topic for hedge funds. Even the smaller funds, whose prime brokers are generally performing day-to-day collateral management operations, are beginning to invest in vendor solutions to audit their contractual responsibilities and take a more active role in margin management, reporting and collateral use.

So what is this relatively unknown practice, and why have hedge funds suddenly begun looking at in earnest?

Collateral and margin management is the process of managing assets pledged by one party to another to mitigate credit risk between the parties and to minimise the effects of potential default. Until very recently, it was always carried out in a piecemeal way, using spreadsheets to monitor and address exposure on lending, using a lack of sophistication which would surprise many observers of the world's great financial engine rooms.

In recent times banks began taking a more systematic approach, as they began to see the operational, risk management and financial benefits of managing collateral centrally, but this still does not explain why enquiries from hedge funds have begun to come to us and our competitors in ever greater numbers.

In fact, a number of factors have contributed to the rising importance of collateral management amongst the hedge fund community: increased regulation; diversification in portfolio strategies; changes to structures and products; more complex offerings; a greater degree of leveraged trading and the use of more prime brokers have all contributed.

The first of these was the great regulatory shake up of hedge funds, which began nine years ago at the time of crisis-management in a volatile marketplace . Recently, Refco proved that, even considering the developing maturity in this space, renewed and invigorated attention from financial regulators on a worldwide basis was entirely justified. The vast amounts of money hedge funds can win or lose in little time and the sheer size of some funds further fuel this enhanced scrutiny.

Of course, during this period, hedge funds have been steadily evolving, not only responding to increased regulation but also 'coming of age' in their use of mainstream investment banking methods, practices and products.

Another major impetus has been the prolific growth of prime-brokerage offerings from the investment banking community. In order to win business in this sector across their entire product range and to create global relationships, new and established prime-brokers have begun to offer complex trading opportunities and additional services, such as banking, foreign exchange and capital market products, to hedge funds.

There has also been a similar move by investment banks into fund administration. Many major international investment banks have acquired administrators in order to step up to the mark rapidly (Bank of Bermuda by HSBC, International Fund Services by State Street, International Fund Administration by the Bank of New York and DPM by Mellon Bank).

The march towards the mainstream

All this has suited hedge funds, which, at thesame time, have been introducing an ever-broader spectrum of trading strategies and an expanded array of products and instruments. In fact, to many, hedge funds look increasingly like banks as they begin to embrace fully the spectrum of traditional, trading-book products. The recent formal AIM listings of RAB and Absolute Capital Management are just two examples of a move towards this centre ground and the institutional markets. These markets are, likewise, marching towards the hedge funds.

Latest figures demonstrate a growing demand for hedge funds amongst the traditional investment community, particularly from pension funds and insurance companies.

Hedge funds have also become accepted by corporate investors wishing to reduce pension deficits through portfolio diversification. The influx of funds is particularly high in this area, and hedge funds are moving even further along the curve into the realm of retail investors (with initial investments being set as low as $10,000). The FSA recently announced that it was to consult on allowing retail investors access to funds of hedge funds, possibly as early as 2007, adding further momentum to funds' march towards the mainstream.

Regulators and prime-brokers are also pushing hedge funds to make greater use of leverage. The FSA recently commented that average leverage levels, at 1.8 times, are seen as moderate, and that hedge funds pose little danger as counterparties to banks. The FSA went on to suggest increasing leverage or borrowings from prime brokers to increase the size of investment portfolios. However, there is a danger of leverage being seen as a separate risk rather than as a magnifier of the common risks. Leverage is also often forgotten as a major source of systemic risk, amply demonstrated by LTCM, which was geared by a factor of 25, all concentrated in one type of strategy.

Current levels of leverage are considered low amongst many of the larger prime brokers, who feel confident they could handle much more, once again driving hedge funds into more risk-laden trading patterns and products. Similarly, as overall returns have begun to fall, especially as the retail market makes its entry, larger investors are now requesting greater leverage from hedge funds and forthem to take greater risks. With this pressure to take greater risk, comes the need for hedge funds to enhance their risk management strategies, and collateral management is increasingly being seen as an important pillar in this.

It is clear there is a new understanding and acceptance of this style of modern investment. Naturally, expansion and diversification is drawing in more regulation and control, and within this, collateral management is making a dramatic impact. Only last summer, the Managed Funds Association applauded the benefits of collateral management for hedge funds. In its recommendations, it described how funds need to monitor and, ideally, manage margin and collateral more actively. Primary benefits are seen as twofold, to satisfy regulators and investors that funds are taking their risks and capital allocations seriously and to enable more effective monitoring relationships with prime brokers, fund administrators and counterparties, ultimately enabling greater returns.

Collateral management systems come of age

Historically, there has been little choice in the market for cross-product collateral and margin management solutions, except for large, global banking focused systems, but new solutions have emerged of late and hedge funds can now benefit directly from business and technology advances originally made for investment banks.

At their best, these new best-practice collateral management solutions (BPCMS) are easy to deploy, integrate, configure and use, as well as being cost-effective and resource efficient. They are geared to achieving an n-dimensional approach from the outset across diverse products. These are essential features for the special needs of hedge funds, which need to handle multiple instruments, across many time zones, strategies and counterparties, in a simple and easy-to-use presentational style. Perhaps most importantly, these systems allow funds to mitigate counterparty risk, and maximise revenues from efficient collateral allocation.

Assessing a BPCMS

Assuming a hedge fund wishes to implement a collateral management system, it needs to assess the system across a number of tasks it is to perform: data collation and allocation, integration of volatile market data, allocation of data to margining arrangements, margin call calculations, and monitoring credit and liquidity risk.

Data collation and allocation

It goes without saying that timely access to a comprehensive range of data is a critical success factor for hedge funds. With funds regularly using multiple prime-brokers across increasingly sophisticated funds and strategies, accurate aggregation of complex portfolio information becomes extremely important. Yet, obtaining the right data at the right time from the right source is not always easily achieved. BPCMS can add value to hedge funds by providing sophisticated, automated data-manipulation functions to streamline and simplify the collation process.

In assessing a collateral management system, managers should ensure it provides:

• configurable, scheduled reception over a full complement of business data, including transactions, positions, movements, market data, securities data and corporate information
• automated support for sourcing market and risk data
• flexible data enrichment or transformation according to rules and constraints
• powerful exception handling mechanisms to deal with data absence or quality
• pluggable 'agents' and services for requesting additional data from external sources whenever needed

Integration of volatile data

In making margin calls and allocating collateral, funds must effectively integrate and assess a vast array of volatile market and internal data, such as prices, rates and valuations but also NAVs from fund administrators, Value at Risk (VAR) figures from calculation engines, credit-ratings and haircuts.

These figures should to be integrated within the general data collation processes to avoid use of stale data, even for reporting purposes, and a good BPCMS will:

• link with reliable and recognised pricing sources, either from organised exchanges for markets or recognised data vendors
• use best market prices or have methods for determining value where multiple "official" prices exist
• verify the accuracy of prices obtained from data vendors, dealers and other sources, and be in a position to explain parameters used in determining valuations and haircuts
• use NAVs and credit ratings as much as possible in CSAs to govern bi-lateral margin call calculations
• have good access to alternative valuation sources for complex transactions such as exotic options, complex derivatives, mortgaged- backed and asset-backed securities
• handle alternatives to mark-to-market (MTM), such as Potential Future Exposure (PFE) and VAR for generating exposure figures, reflecting that different products and market conventions need different valuation models
• manage accruing cashflows or payments or both
• apply rules-based approach to transaction and collateral haircuts
• manufacture additional premiums, add-ons or lock-in margins from special valuations delivered with transactions
• use 'outlooks' and 'warnings' as well as ratings from ratings vendors and the various 'default' measurements from internal risk systems to enable quicker reaction in times of turbulence and volatility
• monitor correlation between corporates, their market sector and their collateralised performance using market indices

Data allocation

The next, potentially complicated, step for a BPCMS involves allocating data to the correct margining arrangements. This is a particularly crucial stage, as deficiencies here can magnify rather than reduce operational and credit risks.

Accurate margin calls are entirely dependent on agreement and portfolio specifications and fundamental to efficient risk and dispersal. In this light, a BPCMS can assist hedge funds to:

• ensure all necessary credit support documentation for trading (whether they be confirmations, term sheets, master agreements or credit support annexes) are in place and are operationally practical
• successfully negotiate and implement standardised terms and conditions to achieve consistency in documentation with different counterparties across different products and asset classes
• track the status of documentation and the negotiation of its key provisions
• ensure that appropriate security interests are created and perfected whenever collateral is received, ideally allowing for controlled, traceable and optimised reuse (rehypothecation) of positions
• handle not only vanilla credit support terms, such as fixed-amount thresholds, but also many more complex, rules-based constructs now being engineered

BPCMS can help control the allocation strategy, which can involve complex reference to many criteria, simultaneously, within the documentation to determine inclusion or exclusion of transactions and collateral for margining purposes. No matter how standard the terms, additional configuration regularly needs to be automatically applied to handle internal and external constraints.

Margin call calculation and communication

Following allocation, BPCMS provides functions to handle margin call calculation and communication. An effective system will add value to the hedge fund by streamlining the business processes and reducing operational risks without increasing resources. A good BPCMS should do this by providing:

• system-wide, roles-based, event-driven configurable workflow
• comprehensive scheduling and deadline management
• work-driven resource assignment, drawing in staff only when required
• straight-through processing

These combine to limit exposure to additional operational risks, such as errors of reconciliation, data quality and timeliness, valuation or risk measurement; access tomarket data or communication breakdowns.

Monitoring credit and liquidity risk

Monitoring these risks goes hand in hand when dealing with margin calls. A well-designed collateral management system will ensure that:

• margin calls can be satisfied on a timely and accurate basis
• only eligible collateral is used and appropriately 'haircutted'
• pledges and transfers are in order, confirmed and perfected upon receipt
• reconciliation of valuations of exposure and collateral to ensure the underlying positions are accurate
• calls for deliveries and returns of collateral from counterparties can be made when permitted
• possession or liquidation of collateral can take place if needed

In summary, BPCMS span many areas of knowledge and skill (not just purely financial), such as legal, documentation, customer, as well as front and back office functions and issues. Accordingly, hedge funds need to do all they can to attract high calibre staff to complement such a system's introduction.

Due to technological advances, fund managers can now take an active part in their collateral and margin management cost-effectively. Investing in advanced technologies that are resource light, user-friendly, fault-tolerant and functionally rich offers a streamlined approach to handling the full range of cross-product, collateralised trading.

The new breed of BPCMS allow hedge funds and prime brokers to address their key collateral and margin management requirements, which are being driven by the fast-changing and complex nature of their markets.

Where can BPCMS add value to hedge funds?

BPCMS can add significant value to hedge fund businesses. These systems should help collateral managers:

• perform regular reconciliations of transaction data with prime brokers to ensure margin calls are legitimate and that valuations are fair. Reconciling margin calls with prime brokers becomes much simpler when all the relevant information is instantly available to managers
• command all the processes around cash margin, playing a strong part in the prudent use of excess cash either to invest, taking into account the credit risks presented by the party in question, or to pledge as collateral against out-of-the-money positions
• generate and distribute portfolio, cash interest and margin statements as well as provide P&L reporting and exports for risk management purposes
• track corporate actions closely: as the pool of eligible assets and collateral broadens the impact of missed corporate actions or badly aligned margin to exposure can be devastating – leading to incorrect market values, trade failures, undesired P&L exposure, client termination, damaged reputations and inadequate margin calls
• utilise system-to-system communication to enable funds, in their fast-paced world, to move to an exception-based, straight- through-processed approach, not only to margin call management but also for general reporting. Theoretically, given that margining terms already include collateral eligibility rules, the entire collateral lifecycle could be managed by such inter-system communications rather than users in the future
• support stress-testing on portfolios and funds. Regular stress-testing and scenario management helps managers determine how potential changes, such as trading new instruments against an existing credit support annex, could impact on exposure, margin and collateral requirements
• consider liquidity analyses by "stressing" the (contractual) rights of counterparties to terminate or otherwise unwind trading relationships or increase margin/collateral requirements upon the occurrence of certain events (such as declines in NAV and credit ratings)

Simon Lillystone is a Director of Allustra, the London-based creator of Kyros, the cross-product collateral and margin management solution.