Given the immense growth of collateral as a primary risk mitigation technique across products, business lines, market players and banking as a whole, it is hard to imagine how today's collateral managers can run their businesses with anything other than the very latest technologies, solutions and analysis techniques.
However, not so long ago for the majority of collateral managers (and, to a certain extent, still the case today for a minority) business was conducted and supported using standard office applications. At the same time, sparse attention was paid to detailed analysis and stress-testing was little known. How was this possible - or indeed tolerable - and what circumstances contributed to the status quo?
First and foremost, collateralised trading historically involved relatively few market participants and represented a very small proportion of total trading. Additionally, credit support annexes (CSA) and margining agreements had typically been difficult to negotiate, for reasons both exogenous, such as the region-specific treatment of close-out netting (an important prerequisite for collateralisation), and endogeneous, such as technological limitations around the ability to consolidate trading information into a central respository. Thus, the take-on of new collateral agreements was slow, existing margining was modest and managing the collateral was not especially onerous. Indeed, these things were often handled on a part-time basis by repo desks rather than by dedicated collateral managers.
Second, the prevalence and treatment of collateral had been predominantly delineated along individual product and business line^s1, making each collateral management function small, fairly limited in scope and bound by product-specific practices.
Third - and perhaps most significantly - even setting aside the silo-based nature of collateralisation, many of the elections and variables within the negotiated agreements were set or geared to inhibit rather than encourage the flow of collateral - fundamentally because systems at the time couldn't support anything other than low levels of activity. Thus, high or even 'infinite' thresholds were very common; monthly margin calls were the norm; one-way contractual agreements were prevalent; cash was often the only type of eligible collateral; portfolio reconciliations were generally avoided and deadlines for margin calls referenced in the CSAs and agreements were largely considered 'for guidance only'.
Current collateral management
The situation now is entirely different:
- Trading volumes are much higher, counterparties are more numerous and from a much wider spread of businesses, eligible collateral is far more diverse (spanning not only cash, bullion, fixed income and equity but also, in some quarters, hard and soft commodities and real estate).
- Rehypothecatio^n2 of collateral is widely accepted.
- True cross-product collateralisation is rapidly becoming a reality.
- Thresholds and other parameters are being dynamically assessed according to credit ratings or even permanently set to zero.
- Daily margin calls are now standard in most market places, while their average value has increased significantly.
- Growth projections for signed agreements have comfortably been exceeded.
In fact, many firms talk of year-on-year doubling of numbers and even by extrapolating the press's oft-quoted 40% yearly growth in collateralisation, a bank with 50 agreements in 1999 (when collateral management first hit the headlines in the wake of the Long Term Capital Management and Russian rouble crises) could easily be supporting 750 agreements by 2007.
Clearly, part-time collateral management is a thing of the past and as it gains in maturity so the emphasis is turning, perhaps not surprisingly, from the documentation to proactive, detailed management of margins, exposures and collateral positions. Additionally, much more attention is being paid to operational efficiencies.
To be effective in this regard, today's managers need access to sophisticated tools and techniques, not only to perform their regular business tasks efficiently (for example, ensuring that margin calls are made according to deadlines) but also to manage their growing, increasingly complex portfolios of exposures and collateral positions expertly. Additionally, with settlement times for margin calls being squeezed, the pressure is on for collateral managers to react quickly and accurately over collateral portfolios worth billions of dollars. So what techniques can assist collateral managers?
Majoring on margin
The focal point of most collateral management activity is, naturally, the margin call: it is the primary interface between party and counterparty and the point at which risk mitigation begins. Aside from the need for timezone-aware systems to ensure observance of the multiple deadlines in different regions, analysis in and around margin calls can greatly decrease risks on a number of fronts. For example:
- Reporting on 'near-threshold' margin calls and tracking this over time can assist in liquidity risk management - helping managers to set aside or expect receipt of funds ready for the moment thresholds are exceeded.
- Producing upgrade/downgrade reports for entities (singly and grouped by industrial sector or location) to illustrate the effect on margin calls of potential movements in credit ratings, net asset value or other credit measures.
- Analysing uncovered transactions found in the global book but not referenced by agreements and their portfolio content rules - a situation perhaps caused by misbooking in trading systems.
- Identifying transactions implicitly or explicitly excluded from agreements that might cause discrepancies in subsequent reconciliation activities with counterparties.
- Comparing agreement portfolios from one margin call to the next or across a period - highlighting new, unstarted, just-started, maturing or just-matured transactions together with alerts for newly identified trading parties, trade types and currencies.
- Publishing differences in populations and mark-to-markets over time using absolute and relative limits to highlight unexpected movements, particularly in valuations.
- Capturing and employing counterparty presented figures for margin calls, not only to streamline the workflow around dispute resolution but also to track over time the variance between these figures against permitted limits and caps. This analysis, in conjunction with reconciliations, can help measure whether or not party and counterparty are converging by value and number upon the same intrinsic portfolio.
For the future, as volumes increase and business diversifies, collateral managers need different ways to review and handle margin calls. Adopting straight-through processing (STP) and exception-based management will help achieve this: using electronic systems and messaging to auto-action the majority of calls and for the remainder, probably those exhibiting the greatest risks, to be handled on an individual basis by importance and priority.
Graphing can be a very powerful tool in this respect, not only for identifying high risks in margining but also any potential benefits (in terms of collateral utilisation)4. The use of colour and images, rather than plain text and data, can instantly provide managers with more targeted information, instantly. For example, plotting collateral against exposure over time for an agreement can quickly show the areas of risk and benefit as shown in figure 1 (overleaf).
Figure 1 also shows the effect of settlement delay and the impact of thresholds, which conspire to accentuate both risks and benefits. One can also observe the see-saw action of the margin call as collateral arrives in arrears of the exposure.
Applying this and other sorts of graphing at higher levels, such as business lines or entities, can yield significant results in terms of effectiveness of risk mitigation and collateral utilisation, and can help collateral managers to control and tune their activities more precisely.
The new diversity of counterparties by type, credit rating, business line and location is also generating additional reporting requirements for senior management and clients, including both historical statistics and trend analyses alongside the more regular outputs. Advanced reporting of this sort enables firms to enhance their relationship management - especially in the private banking and hedge funds arenas - at the same time highlighting their operational effectiveness. It also perfectly complements the other techniques described in this article. For example, providing a breakdown of numbers and values for calls, recalls, disputes and substitutions over a specific period for one or more customers can identify internal as well as external problem areas. This, in turn, can help tune the way in which collateral managers handle different types of customer.
Finally, closer integration between trading, collateral and risk management is leading to new requirements for collateral managers and their systems to perform real-time checks on proposed exposure-bearing transactions and potential collateral positions. With the right technical infrastructure and an enterprise-wide collateral management system that spans the global book (sitting above all trading and risk systems), it is now possible to initiate (from any location or business line) centralised, pre-deal checks on proposed transactions and positions and for the collateral system to respond on the following:
- Collateralised status: is there an agreement in place for the transactions?
- Impact on margin: if there is an agreement, is the initial exposure of the transactions going to cause a call or pledge for initial or variation margin?
- Impact on limits: how will the proposed transactions affect current concentrations levels, limits and caps?
- Impact on pricing: will the collateralised status or the various impacts be reflected back to trading desks in the form of enhanced pricing?
These illustrate that there are many techniques that collateral managers can use around margin calls to improve their effectiveness and generate better relationships with their counterparties.
New collateral challenges
Becoming more sophisticated about the margin call is just part of the picture for today's collateral manager. The increased use of collateral in its many forms and the ever larger and more diverse portfolios being handled are rapidly turning collateral managers from agreement managers to asset managers. This places a greater than ever burden of care and execution over the handling of assets, their related cash flows and corporate actions. Accordingly, today's solutions for collateral management need to be exceptional in their asset management capabilities and offer an integrated infrastructure that supports not only collateral managers but also repo, securities lending and money-market desks as well as information on all asset positions and transactions. Additionally, with the ever-increasing visibility of 'collateral trading' functions, the use of tri-party, the growth of the prime-brokerage/hedge funds business and the general commoditisation of collateral, managers now need to play a much more active part on a far broader field.
When collateral managers looked after over-the-counter derivatives alone, life was relatively simple. Yet, the overwhelming predominance of cash as collateral didn't necessarily make matters that easy, as every month managers would struggle to generate accruals and produce accurate, timely interest statements. Nowadays, to compound matters, the spread of eligible collateral means managers also have to handle coupons on securities and dividends on equities as well as interest on cash and the overall profit and loss (P&L) of their operations.
Furthermore, eligibility rules are far more detailed these days and collateral management systems need to differentiate not only by type but also by sector, issuer, issue, maturity and credit rating, and to handle these separately in terms of held and pledged collateral positions, their respective haircutting rules and their applicability to initial and variation margin.
Concentrating on collateral
It is also generally true to say that collateral managers these days play a much bigger role in their firm's liquidity management, given the high-value, high-volume collateral transactions they handle on a daily basis. Therefore, even at a high level, managers need to use a number of methods to identify the right collateral to give away or to receive and, ideally, do this in collaboration with their collateral and treasury desks. Alongside eligibility criteria, filters on term to next coupon or maturity and largest holding by quantity or value are often the starting points for collateral selection and optimisation. These help reduce the overall number of collateral movements required to satisfy margin calls as well the number of incidental substitutions.
As managers strive to achieve high utilisation - either by offering collateral received to their trading desks or by using it to support requests for margin from counterparties - more aspects of the collateral pool begin to play a part in the selection and preference processes. Some of these are part of the eligibility criteria, for example, credit ratings and maturities, and some need to be derived or obtained from external sources, such as cheapest-to-deliver algorithms.
Haircuts can also come into play as managers evaluate the trade-off between quality, intrinsic value and discounted value when selecting collateral to pledge. At the lowest level, tracking particular issues of securities and for traders and managers to be able to tag these as 'hot items' and monitor their status through event-driven workflow can prove highly advantageous both for trading and liquidity purposes.
Additionally, as collateral eligibility rules broaden, so collateral managers need to be aware of many more characteristics and aspects of the positions and assets they give and take. Recognising the benefits and costs of using one type of collateral over and above another becomes a prerequisite as choice and diversity increase. Major considerations will be how much will it cost to fund a particular position and is there a more cost-effective way of achieving the same result using different types of collateral, assuming eligibility criteria and haircuts permit? Evaluation modelling such as cheapest-to-deliver, cost of funding and cost of carry can answer such questions as well as contribute to a collateral manager's overall P&L reporting capability. For the advanced collateral manager wishing to maximise the value out of the collateral, cost of carry can also identify opportunities for substitution, over and above those brought about by cash flows or corporate actions.
Such algorithms and models will eventually become essential tools for collateral managers as they gradually see harmonisation of their activities with others responsible for funding and liquidity, such as treasurers, repo desks, securities lending and settlements.
Caring for collateral
Once collateral is transferred, managers have to care for collateral in a number of ways. Most obviously, they have to choose custodians and brokers with care and with reference to credit ratings and servicing capabilities. However, another aspect of the care must centre on managing concentration levels.
Baseline concentrations should be measured at the collateral type level relative to their respective portfolios and agreements (for example, the current value of treasury bills in portfolio Z represents X% of the portfolio's total collateral value). However, managers should also report their figures both horizontally and vertically within their asset classes and business hierarchies to discover hidden and potentially undesirable levels of concentration. In the same vein, managers should consider monitoring concentrations against market capitalisations for equities and issue amounts for issues plus aggregated totals for issuers.
Once again, it cannot be more highly stressed that the value of this information will only be as good as the scope it addresses: it is no good a firm having policies about permissible concentration levels against issuers, issues or currencies if the reporting is done on a silo basis with managers having little or no knowledge of positions in other business lines. Collateral managers should also have their own policies on this and set warnings, limits and even caps on concentrations accordingly.
Similarly, collateral managers need to be flexible about their treatment of collateral, knowing what can be used as margin and what cannot, even within eligibility constraints. The collateralising activities of private clients and wealth management programmes are pertinent in this regard since they are often pledging collateral of much higher value than they need to support their exposure-bearing transactions. Thus, a private client might elect that only 10%, 20% and 30%, respectively, of collateral pledged can be used to support trading in derivatives, futures and foreign exchange - leaving 40% unutilised. This 'loanable-value capping' illustrates the way collateral can, in effect, be both a driver of trading and a cap on the amount of trading.
The changing landscape of collateral management is making many fresh demands on the capabilities of managers and their systems. New levels of understanding, responsiveness and operational effectiveness need to be achieved against a backdrop of increased reporting, detailed analysis and stress-testing. Addressing the need for and expert management of a global book is becoming a prerequisite as is developing acute knowledge over exposures, margin calls and mitigating collateral.
New solutions, with state-of-the-art workflow, STP, rule-based margining and global asset management now offer firms, whatever their size or complexion, a cost-effective way to meet these new demands.
Allustra, creators of Kyros, the most innovative solution available for global cross-product collateralisation, is based in the City of London. Its staff share unrivalled experience designing and creating solutions not only for collateral management but also for repo, securities finance and order management, and have worked with many major international banks, including JP Morgan, Nomura, Deutsche Bank, UBS, Dresdner Bank and WestLB.
Kyros, designed and built in the 21st century for 21st century needs, is a pure-Java, XML-based, JMS-compliant, platform-independent solution that can be scaled and configured to meet all needs, traditional, modern and innovative.
Collateral Thinking is a trade mark of Allustra.
1. While cross-product collateralisation is the common goal, significant discontinuities between collateralisation in the foreign exchange, repo and over-the-counter derivatives businesses can be still observed today
2. Rehypothecation means reuse. Previous legal uncertainties and cross-border issues inhibited the reuse of most collateral. Today, by contrast, legal harmonisation and cross-border treaties enable firms to gain a high degree of reuse from the collateral taken - either funding margins to counterparties, utilising for trading or complementing existing liquidity management methods
3. The global book is the collection of all transactions spanning all products, businesses, entities and currencies received by the collateral management domain, whether or not referenced by agreements
4. Risks occur in two primary circumstances, when a firm is exposed to its counterparties and when it has given collateral to its counterparties. Maximum risk occurs when positive exposure is high and collateral given is high. By contrast, beneficial positions are those where collateral taken leads to an opportunity for rehypothecation. Maximum benefit occurs when negative exposure is high and collateral taken is high
Director Allustra Limited
T: +44 (0)20 7539 5702
F: +44 (0)20 7539 5702
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