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Taking collateral management to a new level

Taking collateral management to a new level

Post-crisis regulatory reforms have raised the profile of collateral management within banks from arcane but important to business critical. In short, the increased capital levels required by politicians to avoid another taxpayer bailout require banks to count every last penny, or indeed asset. In response, collateral management has turned from an obscure art into a very precise and time-sensitive science.

Basel III and the G-20 OTC derivatives central clearing mandate are key collateral demand drivers for the sell- and buy-side respectively, with the former’s Liquidity Coverage Ratio obliging banks to hold higher levels of high-quality liquid assets. At a broader level, regulators require a much wider range of financial instruments to be collateralised and centrally cleared, while domestic watchdogs are keen to ensure banks under their supervision are robustly capitalised, all of which serves to slow collateral flows. On the supply side, downgrades and reduced issuance have taken their toll, while impact of the European Central Bank’s (ECB) quantitative easing programme on the availability of high-quality Euro-zone government debt is closely monitored.

Banks that cannot deploy assets as collateral cost-effectively across their business lines, risk finding themselves short of funds and clients. “Banks have fewer high-quality assets to pledge so must become more selective,” says Virginie O’Shea, senior analyst at Aite Group.

Just in time?

For most international banks, collateral management is already a sophisticated activity. Such complex institutions are well versed in the art of selecting from available assets to post collateral that meets a particular requirement in the most cost-effective and low-risk fashion, thereby funding a rapidly-changing portfolio throughout the day.

But many believe we are entering the era of just-in-time inventory and collateral management. Valuing, allocating, mobilising and substituting assets must become faster, more automated and coordinated to maximise the utility of available collateral. While central treasury desks might previously have been aware of repo and securities lending activities across silos, banks are now adopting a more holistic and dynamic approach, making optimal use of all assets on a continuous basis. “We have not yet seen the peak of collateral demand but firms are taking seriously their capacity to optimise. They are industrialising their inventory management to ensure they have the ability to fund their business in the context of today’s balance sheet pressures,” says Olivier de Schaetzen, head of product solutions for global markets at Euroclear.

Front-to-back office coordination is also a pre-requisite. Whether as users or service providers, sell-side firms must adapt to central clearing before their buy-side counterparts. Trading desks will have to calculate margin and assess collateral availability and costs when making trading decisions, inventory management capabilities must accommodate different rules on eligibility and haircuts, while clearing brokers must also help clients to manage collateral. The growing front-office relevance of collateral management also stems from the post-Lehman adoption of risk management methodologies that take account of potential adjustments in transaction valuations arising from collateral and / or counterparty credit costs and default risks.

But few banks are there yet. Many have yet to achieve enterprise-wide inventory management, a task which faces political and organisational challenges as well as systems integration and data normalisation barriers. Banks that are matching assets to collateral needs on a batch processing basis may need to move to real time. “Some banks are able to identify and post the cheapest-to-deliver collateral on a regional or perhaps asset-class basis, but we’re not yet seeing full collateral optimisation across the entire bank,” says O’Shea. “A lot of collateral management is manual and silo-based, whereas the goal should be to automatically substitute collateral, pulling it back and reallocating elsewhere.”

De Nederlandsche Bank notes that many banks cannot identify the opportunity costs because of overwhelming previous use of cash collateral, but observes a trend toward centralisation to handle future requirements. Managed internally or by a service provider, “a central collateral management unit reduces internal fragmentation of collateral by providing a complete overview of all available collateral assets, and allocating these as efficiently as possible, taking the needs of different business lines, counterparty requirements, and netting possibilities into account,” it says .

New era of collaboration

External fragmentation of collateral is also being tackled. Historically, a lack of interoperability between CSDs – differences in message standards, processing schedules, connectivity protocols – have hampered access to collateral, but here too much is changing. Looser rules on asset repatriation under the correspondent central banking model in Europe allow triparty agents to provide more support to firms moving collateral across borders, while collaborative initiatives by ICSDs and custodians are also smoothing cross-border transfers of collateral assets. The ECB’s TARGET2-Securities single settlement platform is expected to help by providing a single view of assets held in Europe.

Euroclear’s de Schaetzen asserts that the new collateral management framework is far from complete. “A key challenge is to mobilise domestic equity assets to support financing requirements on a cross-border basis. This requires greater interoperability between CSDs, custodians and tri-party agents, as existing specialisms and areas of expertise will take time to evolve.” But as collateral demands increase, a dynamic response is well under way.

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