John Burchenal, Managing Director, Market Growth, Omgeo
Nick Newport, Director, InteDelta
The buy side’s focus on collateral management is a direct result of the collateral upheaval experienced during the financial crisis. Market participants explain how investment managers are changing collateral management processes to gain better control over collateral activities and counterparty exposures.
The financial crisis, and specifically the default of Lehman Brothers, shed light on the inefficiencies in current collateral management practices among buy-side firms. Investment managers are improving collateral management infrastructure and investing in technology to address the gaps in operations, but also to satisfy demands for transparency in a new regulatory environment.
Historically, the buy side has taken a more passive approach to collateral management in that most firms received and accepted the collateral calls sent to them from their brokers. However, this passive role in collateral management was based on the assumption that the banks were ‘safe' and creditworthy financial institutions - a belief that was changed indefinitely by the events of the credit crisis, explains Nick Newport, director at InteDelta.
"Buy-side firms are now actively managing their collateral as part of wider counterparty risk management frameworks. The focus now is on avoiding future counterparty risk exposures by improving technology to support new business processes around collateral management,” Newport said.
Both traditional investment managers and hedge funds are investing in collateral management infrastructure however, the focus of improvements varies by type of institution, explains Newport. “It is more of a new process for the traditional investment managers whereas for the hedge funds, the focus is more about managing collateral in a more effective and optimal way,” he added.
Hedge funds are generally more knowledgeable of collateral management and related risks, so they are more likely to be improving the sophistication of systems already in place to optimize collateral. By contrast, the traditional investment managers have less experience with collateral, and therefore have a steeper learning curve in that they must first understand the collateral management processes, what a platform looks like, and how to put a robust collateral management infrastructure in place.
A manager at an alternative investment firm in Europe weighs in:
“We are starting the process of investing in collateral management technology now,” he said. The main drivers revolve around the optimization of margin management and improvements in stress testing capabilities, he added.
The investment firm is looking to implement new collateral management technology that allows efficient optimization in use of margin, but also getting the correct margin calculation so it can cross-reference its calculations with the figures prime brokers provide. Also, the fund manager will invest in technology to boost more stress testing capability so the buy-side firm can better predict the outcome of changes in the market from a risk management perspective. The stress testing technology must have the capability to add new sets of rules into scenarios so one can better negotiate margin during different market events, the manager added.
Additionally, the buy-side manager is also improving its reconciliation process for both cash margin and position management. “We have become very suspicious of bank’s ability to calculate interest rates correctly and we are not willing to just take their numbers at face value, so we need to make sure we can do this correctly,” the manager said.
There is also an “economic element” to improving reconciliation processes. Rather than pure position or cash reconciliation, increasingly buy-side firms want to be able to monitor assets on deposit, or borrowed, and the changes on these positions and related cash balances. The firm needs to also know what will happen if a settlement fails and how much margin or interest would be charged. It is important for an investment manager to have a handle on this entire reconciliation process and is able to check the relevant calculations are correct, the buy-side manager added.
The buy side’s investment in collateral management infrastructure represents more than improved management of collateral and counterparty risk – it coincides with a move towards self-reliance and establishing a better balance of power between buy side and sell side, said John Burchenal, managing director of market growth at Omgeo.
Due to the historical reliance on the sell side for information about collateral requirements, the buy side didn’t necessarily have the tools to be able to know if the collateral call was accurate. In this situation, where the buy side relied heavily on the sell side’s provision of collateral information, there wasn’t much transparency. However, now that the buy side is implementing new collateral management tools to allow them to better control their collateral, they will have the information and wherewithal to dispute calls if there is a discrepancy between the brokers provided information and what is calculated internally, said Burchenal.
He said: “This change puts [the buy side] on a much more equal footing with the sell side. It is becoming more of a balance of power and that is what the regulators in the industry certainly want in the OTC derivatives space.”
This shift in power is already evident in the negotiation of prime broker contracts and credit support annexes (CSAs), said the buy-side manager.
“At the moment, we are seeing greater reliance on legal documentation than ever before because firms are looking closely at what the rules within the documents and agreements, including prime broker agreements. The practice of simply placing a trade with a broker and waiting to see what comes back is no longer common. Getting a prime broker agreement agreed takes months of negotiations now rather than just accepting the agreements banks automatically send along,” he added.
The buy side is taking the protection of assets one step further by setting up segregated accounts for collateral. “Many buy-side firms are now pushing for a segregation of independent amounts and are looking to set up separate accounts with third party agents or custodians. Use of segregated accounts should allow a firm to get the independent amount back in the event of a counterparty default,” said Newport.
The segregation of assets is a product of the financial crisis and specifically the Lehman Brothers collapse because many firms discovered their independent amounts were attached to the same rights and agreements as the rest of the collateral balance. Therefore, the independent amount could only be extricated during the administration process, explains Newport.
An emerging trend within the buy side is the changing view of collateral management as more than just a cost center. “[Collateral management] is a business enabler if you get it right, said the buy-side manager. “The potential benefit in terms of increasing profitability is pretty minimal, but you don’t want to get it wrong, as this will take away from profitability,” he added.
Newport agrees: “The amount of profit to be gained is largely insignificant compared to the amount of benefits to be achieved from using collateral as a business enabler. It is more about making sure you don’t get it wrong rather than getting an extra basis point out of it.”
Some investment managers however, do see ways collateral can be optimized to boost the bottom line and thus push this operation to look more akin to a profit center, said Burchenal, though he acknowledges this is a newly emerging perspective. "If you're able to optimize the use of your collateral you're able to better your returns and [collateral management] therefore then becomes profit center,” he said.
This is especially true for non-cash rich investment managers, Burchenal explains:
“More than 80% of all collateral is cash, so cash is king in the collateral world and if you are a buy-side firm, do you really want to use your cash as collateral?” asks Burchenal. “Using cash for collateral is not as productive because most firms would rather invest the cash to get a portfolio return.”
Using securities for collateral is a much more complex process compared to cash so many investment managers have avoided using securities. The use of a robust collateral management system would however, provide the tools and support for the entire collateral management lifecycle for securities and would also provide various options for a firm to better optimize use of collateral and maximize returns, Burchenal added.
Of course implementing a robust collateral management infrastructure has many challenges. In fact, technology is a challenge in itself, said the investment manager.
Technology provides the tools to help improve collateral management processes but when it comes to the use of this information, the firm ultimately has to complete the analysis to ensure the information takes into account non-computable factors. “There are too many different factors involved that need to be considered such as, the management of the existing dealer relationships with prime brokers and how this impacts a firm’s allocation on new deals and leveraging of a relationship when necessary.”
For example, if a buy-side firm does a lot of business with one bank then it might be in the manager’s best interest to pay a little extra to keep the prime brokerage rate going even if the data provided by the system says that other prime brokers offer a more affordable price. We need to reconcile what is best from a relationship perspective with the data that comes out of the system to look at the much wider trading relationships as a whole rather than on a simplistic and unqualified view. “The technology solutions are there to help us come up with an answer, not to provide the answer,” the buy-side manager said.
Uncertainty in the market and regarding regulatory changes poses both a challenge and a driver for buy-side firms, said Burchenal. “A major challenge for the buy side now is not knowing what they are required to do because of the unsettled regulatory environment because while firms do know certain requirements they will have to comply with, they do not yet have the full picture of what else might be required of them in the future.”
One of the main elements of financial regulatory reform is transparency, said Burchenal, who noted firms would need to have a ‘real-time’ control of collateral to satisfy new reporting and compliance requirements. “Having a handle on the inventory of the collateral positions and related exposures at any given time will give a firm the ability to provide the transparency it is under the heavy burden to produce,” he added.
Also, clients are aware of the importance of collateral management and want confirmation that infrastructure and procedures are in place to control collateral activities and related risks. “The financial crisis has highlighted some of the serious issues the buy side need not only address for their own financial health but to assure customers and keep up one’s ability to attract new assets in the future,” said Burchenal.
A perfect example of the market uncertainty is the introduction of central counterparty clearing (CCP) for credit default swaps and other Over-the-Counter (OTC) derivatives.
The buy-side manager said it would wait to see ‘when the CCP services are more firmed up’ as to how the firm will access and use central clearing facilities.
“While the CCPs are meant to simplify the world, for the buy side it is actually going to make it more complex,” warns Burchenal. Investment managers will have to deal with CCPs either directly or via direct clearing members (DCMs) for the clearing for some transactions, but will have to execute typical bilateral agreement with other transactions. So, at first central clearing will make life more complicated until the full scope of the CCP initiative is defined.
Of course, more unexpected challenges are sure to come, said the buy-side manager.
He said: “In May the market had been testing the collateral systems and all have held up well but [the market situation in Europe with the crisis in Greece] was nothing like it was in 2008 where the counterparty risk and systemic risk was sustained. The next challenge for [our collateral management operation] will be testing to see if the changes made withstand the next crisis." |
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