To make the most optimal use and re-use of collateral, banks are enhancing the management of their collateral inventory.
Improvement of the management of collateral inventory has been on banks' agendas well before the credit crisis hit in 2008, but greater interest in using and re-using collateral more efficiently and to gain economical benefits has pushed this initiative to the forefront of many banks’ 2011 plans.
“The primary driver [for improving collateral inventory] is optimization,” said Nick Newport, director at InteDelta. Firstly, financial organizations want the ability to re-use existing collateral inventory, and secondly, to optimize that re-use of inventory.”
During the financial crisis and recent months of market volatility, the frequency of margin calls increased significantly for many firms. To cope, some financial institutions borrowed assets to cover specific margin calls, but this is an expensive way to fund collateral. Banks are now looking to utilize existing collateral assets as a more cost-effective way of financing.
“We are really trying to make sure what collateral we are receiving we can also give out, so we do not have to finance that collateral in some other way,” explains one collateral practitioner. This firm, for instance, may not want to receive certain types of products, such as a corporate bonds, as collateral if it has to then pay out a higher-rated product for use in other collateral activities, he suggested.
“There are various inputs an organization will use to determine what is the most optimal piece of collateral to give first," said Newport. This optimization process can be quite complex and may use different algorithms to identify the most optimal asset to place, and to accommodate the various ways different parts of an organization will try to optimize. For instance, a bank might want to pledge assets with the lowest haircut first, or the asset with the lowest rating, he explained.
Access to inventory helps improve the speed and efficiency in which a bank can respond to collateral obligations, and there is a clear economic benefit to this.
“All players have to have the economic usage of the collateral pool because this is very important to generate additional income, to receive cheaper funding, and to optimize your repo trading activities and margining,” said another collateral practitioner. For example, banks are needing to post collateral on an intra-day basis, especially during more volatile market conditions, so it is critical for banks to be able to move internal collateral assets to different desks, locations and time zones to meet various obligations, said a practitioner.
In addition to the economic benefits through optimized use of collateral pools, the market focus on liquidity has further reinforced the movement towards improving controls of collateral management on an enterprise-wide basis. Regulation, specifically Basel III, requires banks to have better control of collateral to prove effective management of the firm’s own liquidity, said a practitioner.
“It is important for a firm to have the ability to manage its collateral inventory, not only on paper, but also in real-time to meet regulatory requirements,” he said. For example, regulators are looking at how firms access inventory and if the firm can access this during times of crisis to support its liquidity risk model. Managing collateral inventory is the first step in showing the controls and operational procedures are in place to keep on top of collateral movements and to manage the firm’s liquidity, the practitioner said.
From a liquidity management perspective, it is important to have a global view of where the collateral inventory is held, how it is held and what system is used to manage this collateral and transfer it to the trading system or middle office. A bank needs to have the overview of collateral included in all branches, trading units and liquidity reserves to see both the entire picture and where it can best utilize those assets.
Managing collateral inventory across desks, business units and locations is not an easy task due to organizational and technical challenges in bridging across the silo structure most banks operate within, said John Burchenal, managing director of market growth at Omgeo. However, many banks are bringing the silos together to create a single collateral management regime that allows everyone to tap into the inventory that exists on an enterprise-wide rather than desk-wide basis, he added.
“The nirvana is to have this enterprise-wide system for all collateral inventory so you have a process that allows you to measure risk, and to use the inventory to gain returns through optimization,” said Burchenal.
The shift towards an enterprise-wide view of collateral supports growing interest post-crisis in collateral management from senior management and other departments who are more aware of collateral's role in managing a firm's overall risk, he said.
Creating a more holistic management structure for collateral requires greater coordination of various departments and desks – areas of a bank that have not historically had direct input into the collateral management process.
As one practitioner explains: “Before we managed [collateral] ourselves and if we got stuck we would go to the financing desk, but now we have other desks that are giving us direction…and have views on what they want us to do.”
To make a centralized collateral inventory structure work requires not only the buy-in from the various desks, but also greater proactivity from the front office, explains Burchenal. “Traders will have to be diligent about updating their trade positions on an almost real-time basis so all traders understand their positions,” he said.
Buy-in and greater coordination also needs to take place throughout the various departments including legal, information technology and the back office to produce processes to satisfy both internal and external requirements for collateral management, adds a practitioner.
He said: “The key driver is that you have to raise the internal knowledge [of collateral], interact with your various departments, and have the back up of management because otherwise it's not possible to improve [the collateral management] infrastructure.”
From a technical perspective, the major operational challenge in managing collateral inventory more holistically is the requirement to centralize data from multiple asset classes, desks, locations and business lines.
“It is a major infrastructure and technology challenge to do it properly," said Newport. "Pulling all the data together, understanding what the status of the inventory and all the positions are, is a major data and infrastructure challenge.”
Banks strive to have a clear, transparent, and up-to-date view at any given point in the day of where the inventory is, and this may require pulling data together from multiple systems within the organization and external feeds from custodians and central securities depositories, to get a clear understanding of what is being held and the availability of assets, explains Newport.
Once a bank has this comprehensive view of collateral inventory, and is able to monitor with certainty the basic movements across an organization, the firm can then develop sophisticated analytics to optimize the use and re-use of collateral. For instance, firms want to be able to automatically deduce which assets are best used in certain scenarios or where collateral can be used, or traded to add value.
“This is a significant piece of work because we are developing new sections of a system that do not even exist today,“ said a practitioner. The bank currently has the system capability to collect collateral, determine its eligibility, but the system cannot analyze the collateral to assess what asset is best used for a certain scenario. The firm aims to develop a model to build this analytics capability to maximize collateral once it has gathered the specifications from various departments on preferences, he said.
For many banks, the end goal is to optimize collateral to meet margin obligations, but to also enable the banks' reuse of collateral for trading activities, such as for use in securities lending.
Flexible technology is essential to support this level of optimization.
“The key point is the flexibility of the technology to enable organizations to implement their tools in the way that organizations want to manage its process,” said Newport. Specifically, flexible technology is required to support the use of different optimization parameters, calculations and to manage the availability of the inventory itself, he added.
Many banks will rely on a combination of internally built and off-the- shelf software to support collateral inventory management, and, as a result, industry vendors are developing better capability to cater to new market needs, Newport added.
Many banks reviewing collateral management software this year are well aware that inventory management and optimization capability must be considered, said a practitioner.
He said: “Organizations looking to buy a new collateral management system a year ago didn’t really need to look at [collateral inventory management and optimization], but now they do.