The New Collateral Environment

How regulation has moved collateralization to front office

Originally published in the October 2015 issue

Until 2007, the process of collateral allocation was just that: a process. Before the crisis, derivatives traders – predominately banks and large asset managers – would post collateral to each other, protecting against the prospect of default. Back then, it was a relatively simple, operational concern – choose some collateral, post it to the deal, move on to the next one. But today it is much more than that. It is strategic, with significant consequences for return on equity – and therefore profitability.

The good old days
Before the crisis, a deal that needed collateral would generally see collateralized cash posted to it. Cash was cheap, it was simple to get your hands on; it could be borrowed easily. Many banks could fund a large percentage of their balance sheet overnight. This meant those working the deal could focus on the investment itself, and didn’t worry too much about where the collateral was coming from – or what form it was taking. However, the crisis’ regulatory fallout changed all that.

Goodbye 2007, hello regulation
Following the crisis, a raft of new regulation – EMIR, Dodd-Frank’s Title VII and AIFMD – arrived to prevent a repeat of the events of 2007. The seismic impact of these regulatory changes altered the collateral landscape, making more deals subject to collateralization, while denaturing many of the traits that made cash effective collateral in the first place.

Banks must now fund over a longer term, while holding more capital against uncollateralized trades. This combines to raise the cost of cash while reducing the volume of cash available to lend. Furthermore, banks must trade through clearing houses, requiring variation margin on top of initial margin – which means yet more cash is needed as collateral. These factors inevitably create a cash shortfall – and that’s before we consider the need for collateral to be posted more frequently, and the sharp growth in market participants who are subject to posting it.

However, it is not just cash that has become more valuable. There is a general collateral deficit, thanks in part to buy-side requirements to post collateral that is not only better quality – but diverse too. What this adds up to is the ‘collateral crunch’. This shortfall in suitable collateral must be met by a process that can ensure there is enough collateral to meet the demand of dealmakers. That process is known as collateral transformation.

Collateral transformation
On one sidewe have the banks. They must post more collateral and hold more capital. This is hurting their return on equity; it’s making them look unprofitable. So they need to be smarter and more efficient, because collateral, that checkbox eight years ago, is now a valuable resource.

On the other side there are funds and asset managers, and they need cash or high-quality bonds to post as collateral. Unfortunately, a buy-side worth its salt will likely have a higher proportion of high-yielding assets like equities or corporate bonds, because that’s their business – driving yield.

So now they need to temporarily swap these high-yield assets for the safe ones that will meet regulatory requirements – such as cash or government bonds. When they do this, they hurt their return – and pay a fee to the banks for the privilege, who will charge for swapping these assets. So now the buy-side has a headache, which can only be soothed by smarter, more strategic allocation of collateral.

Smarter collateral
Collateral optimization, put simply, is the process of making sure your collateral is allocated efficiently. For example, a bank would avoid posting cash because cash is an asset they could lend and generate a return on. As collateral, cash generates nothing. So banks may instead seek to post government bonds, assets that would otherwise sit on their balance sheet.

On the buy side, they need efficient systems to help them post collateral more frequently, and challenge the amount required in margin calls from banks. Meanwhile, the Alternative Investment Fund Managers Directive (AIFMD) means alternative investment fund managers need to find a depository to segregate house assets from client assets – while ensuring the assets belonging to the house are easily identifiable and distinguishable from those belonging to clients.

It’s important to remember that collateral optimization doesn’t begin with STP and algorithms for managing your collateral distribution: it begins with clear oversight. The key to efficiently and effectively optimizing collateral is knowing – and being able to visualize – your entire position, including collateral and exposure, your agreement terms, the collateral pledged and your inventory.

Once you have captured this properly, with high-quality market data, you can begin to optimize collateral efficiently. And only then will technologies like STP, collateral automation and smart, readable algorithms be of benefit to your operation.

In conclusion
What was historically a back-office function, which had little to no interaction with traders and the middle office, is now moving to the front office. In order to manage collateral effectively, traders, risk analysts and collateral managers must work as one – which is where good systems can help. A good system will connect all three functions with live data and company information. It will enable them to communicate with the market, and will provide risk and simulation analytics, with access to trading systems.

Without a doubt, collateral management is more challenging today than it was eight years ago. But by breaking down operational silos and taking a holistic view of investments, firms can place themselves in the best position to cope with the changes and prosper in a derivatives market that is, ultimately, safer and more secure. Know your exposure across all traded products. Calculate margin calls across all collateral agreements. Get these basics right and you can allocate collateral based on a full view of available asset inventory.