Collateral management 'global warming' - theory or fact?

Lombard Risk

Over the past nine months I have personally seen an immense increase in the demand for collateral management technology across all sectors of the market fuelled no doubt by the growing demand for credit lines by highly leveraged institutions (mostly hedge funds), the various risks associated with that and an appetite to mitigate effectively. Although this 'global warming' is not quite unexpected, the intensity of the demand is quite an interesting development given the seven-year time-lapse since the woes of Long Term Capital Management and the subsequent recommendations by the Report of The President's Working Group on Financial Markets in April 1999. So, it begs the question - what has changed?

Historical warming

Collateral management has come a long way over the last decade and one could almost be forgiven for saying that it was once a 'back-of-an-envelope' activity. It has, however, now progressed from single-confirmation-based collateralisation to cross-product margining and all top-tier banks now have dedicated departments responsible for the margining of over-the-counter derivatives, repo and securities lending products. The International Swaps and Derivatives Association, reports the number of transactions included under bank-to-bank collateral agreements is at an all-time high, while the Caribbean, with its high number of registered hedge funds is seen as the third-largest region for collateral management activity.1

In today's world, banks can have collateral agreements with literally thousands of counterparties and, quite apart from pure risk reduction, collateral does offer other tangible benefits such as the ability for banks to enter into more complex or structured products, trading in emerging markets and more longer-dated transactions - all higher risk but higher margin transactions. Another important factor is that, with the advent of Basel II, which enlarges the types of collateral to which capital adequacy haircuts can be applied, banks can release credit lines by holding collateral and this is another very important business driver.

It is now commonly accepted that if, for example, a hedge fund is to trade over the counter with a sell-side street name, they must do so on a fully collateralised basis. This means that every interest rate swap, equity option and credit default swap is likely to be governed by an Isda Master Agreement and Credit Support Annexe or Prime Brokerage Agreement. Consider the fact that there are reported to be over 5,000 hedge funds globally with around 27% of counterparties in large collateral programmes being cited as hedge funds. Couple to that the dominant strategy of China in the world energy markets over the last year, the rising volatility in that sector with apparent disregard of future prices; it suddenly becomes very clear that managing risks with prices at the level where they are now is not child's play.

In addition, the market pushing people to take more risks - in essence much of the 'easy money' has already been made, so default probabilities are likely to rise in parallel - making effective collateralisation an essential part of any bank's credit risk policy.

Drivers from the flip side

In my dealings with hedge funds, asset managers and corporates over the last 12 months, it has become clear to me that they are taking the collateral management function much more seriously. It seems apparent that there is a move afoot where they are no longer prepared to leave it down to the sell-side bank or prime broker to advise what collateral is required and when they want it. Signing over valuation agent rights to the sell-side does reduce the workload for the fund in one go, but leaves the fund open to the demands, requirements and potential errors of the sell-side. With only a handful of agreements across a small fund this can make sense but, as the fund grows, it becomes less desirable and it seems that alternatives are being sought.

This brings to me to an emerging trend, traditionally taken care of by fund administrators such as International Fund Services who have been running collateral management functions on behalf of their clients for some time with growing success, but now also being taken seriously by prime brokers and other sell-side (even custodian) banks - and that is collateral outsourcing. This entails a 'one-stop-shop' solution, which offers the management, valuation of underlying transaction details and movement of collateral assets consolidated into one environment, a service for which clients are generally happy to pay extra.

What we are also seeing now is that smaller regional banks, building societies, fund managers and so on are also preferring to take the outsourced route, but with the added demand to have access in a 'customer self-service' style to their information and reports via the internet. Clients are specifically demanding access to their collateral statements in real-time, with the ability to make certain decisions regarding what collateral is to be moved and, most importantly, to have access to 'how' exposures are being calculated. This way it is said that outsourced clients can actually control the pushing of delivery statements to earlier in the day for example, giving them more time to respond to collateral calls, and calling margin back, for example, if and when the markets shift.

Technology options

Doing collateral management badly can be worse than not doing it at all and, to handle the apparent global warming effect (or increase, if you will) of the use of collateral, the biggest challenges facing banks today on this technology front are a lack of automation, consistency and accuracy of data, cross-product capability (not just OTC products), consistent processes and an overall simplification of the collateral process.

In terms of solving these issues, we are seeing another surprising emerging trend of banks breaking down the 'let's develop it-in-house' Holy Grail. At the time when most large banks were looking at buying off-the-shelf systems some 10 years ago, there was a general lack of functionality in the collateral management space, and so many systems were built in-house.

But times have changed: 'collateral global warming' has meant the demands on technology to handle the sophistication now prevalent and demanded in the management function, cannot be handled by those legacy systems any longer. Although many vendors have also failed to keep up with the times, new solutions have emerged in the form of new-generation packaged applications using the latest technology, such as Colline(R) from Lombard Risk (www.lombardrisk.com). This means that large and small banks can shop for robust and scalable solutions developed by experienced collateral management practitioners and that many of the painful issues associated with internal development can be avoided, while the considerable benefits of effective collateral management can be fast-tracked.

From an outsourcing perspective, sell-side banks or prime brokers considering to get ahead of the curve and to protect their current client base from scavenging from others who will shortly be offering these services, will no doubt want to fast-track their entry into this field at the lowest possible cost and time to market. I would suggest that important benchmarks for in-house application or offering an outsourced service are:

- Scalability - the chosen technology must be able to handle increasing volumes and user loads as the collateral function and organisation scales up.

- Total cost of ownership - consider the operational load on support staff to administer and maintain the solution. It should use web-based thin client user interfaces to obviate it having to be rolled out to every desktop that needs it and updated there.

- Currency of base technology - it should be founded on tried and trusted technology that is current in the market and has a buoyant future.

- Ease of data integration - collateral is quite intensive in its demands for inputs from multiple sources. The solution must have a robust and clear interface to enable the data transfer with little effort.

- Platform compatibility - make sure your vendor supports platforms that are already in place, otherwise it will require non-standard support and the associated costs such support involves.

- Configurability - off the shelf is never quite a perfect fit - make sure the solution can be adapted to work practices.

- Partnership mentality - really important for a vendor to work with the bank to ensure the system stays current. Look for a 'hungry' vendor that will ensure that the solution stays current and at the forefront of business requirements in the industry.

- Customer self-service - the solution should be able to handle this out-of-the-box - customers must be segregated from internal users. Customers must be able to access and view reports and collateral movements easily via the internet.

There is little doubt that collateral management 'global warming' is a fact, but the good news is that technology is keeping pace and can protect against any harmful effects. Making the right decisions sooner rather than later will minimise your exposure and maximise your revenues to boot.

CONTACT

Cliff van Tonder, Chief operating officer & group sales director

E: Cliff.vanTonder@lombardrisk.com

Mark Higgins, Product manager, Colline

E: Mark.Higgins@lombardrisk.com

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