If you are deployed in the Investment banking space front office, middle office or back office, you should have come across phrases such as “collateral liquidity crunch” and “collateral scarcity”, and new terms such as “collateral transformation” and the “collateral upgrade trade.
Came across an interesting paper on Collateral management sharing some of the highlights, need for collateral management, how we got there, some of the Best Practices to collateral.
The 2008 financial crisis and the role derivatives played in it compelled regulators to re-examine and reengineer the entire derivatives market structure. The disruption to the derivatives market is already underway, primarily as a consequence of behemoth regulations such as the Dodd-Frank Act (DFA), European Market Infrastructure Regulation (EMIR), Basel III and others. But new global regulations are not the only driver. Business practices are changing because of increasing pressure from stakeholders, such as boards of directors and institutional investors, for improved transparency, standardization and risk management.
An inherent part of bi-lateral swap transactions is the associated counterparty risk, and the means to collateralize that exposure will always be a paramount risk management function. Given that counterparty risk is tied to swap transactions, it is important that investment managers understand that this risk assumption can be mitigated – though not eliminated – through robust operations, sophisticated technology and a strong commitment to collateral management. While counterparty credit risk will remain a constant, how it is managed is in flux. Collateral management practices will increase in importance and must change to accommodate the emerging derivatives market structure. While the drivers and implications of change can be different for an asset manager as opposed to a diversified global bank, in either case, accommodating tomorrow’s collateral management environment requires a new strategy.
To bridge the gap, some of the key steps to develop new collateral management best practices include:
– Improve eligible collateral inventory management tracking
– Institute sophisticated collateral optimization tools to ensure the most efficient collateral usage
– Identify opportunities for netting across counterparties and asset classes
– Develop tools to analyze collateral implications before a trade is executed so that the optimal execution path is followed
– Explore the need for collateral transformation services
– Build capacity to increase the frequency of collateral substitutions without straining operational resources
– Minimize operational pain points (e.g. settlement fails)
A combination of the above actions should alleviate collateral pressures faced by the front office. There are several paths asset managers can take to adapt their infrastructure for the industry’s new collateral management model. Certain managers may opt to manage this function in-house. Others may have a desire to outsource the collateral management function to a provider that has made the investments, lived the market’s evolution, and consequently has deep knowledge about the new practices impacting asset managers.