With the uncleared margin rules on the horizon, the buy-side is engaging with collateral management and optimisation more than ever before. We look at the issues triggering this engagement and examine how an effective approach to collateral can place firms in good stead in the face of change.
While collateral management may have been a focal point for some of the largest and most forward-thinking asset owners and asset managers for some time, regulatory change and mounting collateral obligations mean that buy-side firms of varying types and sizes are increasingly turning their attention to how to optimise their approaches in order to best leverage collateral and comply with regulatory requirements.
“The buy-side is now more engaged in collateral management than ever before,” says Nicholas Newport, managing director at consultancy InteDelta. “There are many drivers but the real game-changer is regulation, in particular the move to mandatory and standardised rules around variation margin and initial margin for uncleared derivatives. Nor is this just in the traditional markets, we see significant interest in collateral management across Asian markets as well as Europe and America. Global regulatory standardisation has created a common conversation across most jurisdictions which have any meaningful derivatives market.”
The uncleared margin rules (UMR) involve the mandatory exchange and segregation of initial margin (IM) on non-cleared derivatives trades as part of a framework designed to reduce systematic risk and promote central clearing. The rules were originally due to be rolled out in five phases to capture firms with an aggregate average notional amount (AANA) of non-centrally cleared derivatives greater than €3 trillion, followed by €2.25 trillion, €1.5 trillion, €0.75 trillion, and €8 billion, with the fourth wave (€0.75 trillion) most recently coming into effect in September 2019.
The first four phases have mostly impacted sell-side firms and some of the larger buy-side firms, with many smaller buy-side firms due to be swept up in the final wave, which was expected to be implemented in September 2020. In July 2019, the Basel Committee on Banking Supervision and the International Organisation of Securities Commissions (IOSCO) announced that the €8 billion threshold would be delayed until September 2021 and an additional phase for firms with an AANA of non-centrally cleared derivatives over €50 billion would be introduced in September 2020. This followed on from the Basel Committee and IOSCO’s March 2019 announcement clarifying that documentation, custodial and operational requirements only apply if firms’ bilateral IM amount exceeds a €50 million IM threshold.
Although this has pushed back the date on which some buy-side entities come into scope, preparing for UMR is not an insignificant undertaking and those firms benefiting from the extension can harness the additional 12 months to ensure they are well positioned for September 2021.
“The uncleared margin rules require firms to sign the appropriate legal documentation with custodians and conduct a broader negotiation of agreements. Overall this is a huge job,” says Martin Seagroatt, marketing director for securities finance and collateral management at fintech firm Broadridge.
Many buy-side firms will likely be unfamiliar with the processes and obligations associated with the IM rules and may not have the level of resources or in-house expertise available to sell-side firms that have already fallen into scope of the UMR’s initial phases.
Remaining connected at an industry level could assist firms in building familiarity with the topic, notes Katie Emerson, head of securities lending and collateral management for EMEA platform sales at J.P. Morgan, for example engaging with trading counterparties, industry utilities, peers and associations, as well as leveraging the experience of providers who have partnered with clients through previous phases of the regulation.
“Firms should be speaking to experienced providers so that they can start to plan accordingly,” says Ed Bond, head of agency securities lending and collateral management, Asia Pacific at J.P. Morgan. “They need to think about resources and local regulatory requirements, in addition to new requirements such as the appropriate calculation methodology. The sooner they have understood the work required and developed an implementation plan with detailed deliverables and timings, the sooner they can identify any gaps and prepare for them.”
When doing so, it is important to take into account all of the components touched by the rules, adds Emerson. “Often firms are very focused on needing a custody account to hold the collateral related to the initial margin but they also need to be thinking about all of the ‘upstream’ components that are required before they even get to the stage where they hold the collateral, such as IM calculation, movement, and settlement.”
As well as triggering buy-side firms to re-evaluate the way in which they manage collateral, IM collateral eligibility criteria could also bring to the fore new considerations around the types of collateral firms hold. Roy Zimmerhansl, practice lead at Pierpoint Financial Consulting, says: “They need to ensure they have access to good collateral and if not, then securities finance transactions may be used by buy-side firms that need to find securities that will be acceptable as collateral in their bilateral arrangements.”
UMR may be the most significant regulatory driver for the buy-side when it comes to collateral but it is also accompanied by a desire to squeeze more revenue from securities finance to offset fee compression, points out Seagroatt. “Buy-side firms are therefore becoming more engaged in collateral management and more innovative in the various structures required to support collateral upgrade-downgrade trades for example,” he says.
Alvin Oh, global trading product owner at EquiLend, a provider of trading, post-trade, market data and clearing services for the securities finance industry, notes that buy-side participants are also looking for efficiencies across trading platforms to net their exposure. He says: “Because GC spreads have come down, firms more than ever need to maximise their books and make smarter use of their inventory. In this environment, more robust risk management and collateral management flexibility are increasingly important.”
Joining the dots
The growing focus on collateral management has led firms to take a more holistic approach, enhancing transparency around collateral availability and obligations across business areas.
“Buy-side firms now have to be more aware of their collateral positions; that will let them determine how best to leverage the collateral that they have and how to optimise its distribution,” says Bimal Kadikar, chief executive officer at collateral and liquidity management technology provider Transcend. “We have seen examples of larger players consolidating their desks and mid-sized players implementing further governance or processes in order to increase connectivity between silos, such as securities finance and derivatives.”
Looking at the bigger picture, encompassing all of the ways in which a firm uses collateral, can help to inform decision making and enable the buy-side to gain as much value as possible from collateral. “What firms would not want to do is give up the intrinsic value in certain trades, such as in agency lending, because they are using that collateral for other needs when there could have been an alternative option available that would have been more cost effective,” explains Bond.
Ensuring that front, middle and back-offices are aligned also has a key role to play here. Indeed, collateral management is increasingly moving from a back-office to a front-office issue as firms recognise the impact an effective collateral strategy can have. Bond says: “In Asia Pacific, for example, some of the most sophisticated buy-side institutions, such as the bigger pension funds and insurance companies, are now hiring experienced front-office personnel from the sell-side – they are really driving the activity.”
Adapting to new requirements
Before firms can begin thinking about collateral optimisation or collateral transformation, however, they must first have the appropriate systems in place. Newport says: “The first and fundamental consideration is how to put in place all of the necessary infrastructure and processes to be able to efficiently manage collateral from an operational perspective in order to meet regulatory compliance. For many firms, it was not necessary to think about this before and now suddenly they need to put in place capabilities to meet quite a high bar of operational sophistication. Even for those buy-side firms which have managed variation margin calls for many years, the requirement to exchange IM adds a new level of complexity. Industry service providers and utilities, such as triparty agents, collateral agents and calculation and reconciliation hubs, help tremendously with this challenge but bring new puzzles of their own - which providers to use, how to manage the data plumbing, what to retain in house, and so on.”
Whether or not firms look to build in-house solutions or leverage outsourced services for collateral management and optimisation often depends on their size and the availability of internal resources, as well as considerations around cost, efficiency, and access to the levels of expertise and sophistication of technology that meet the complexity of their needs. Todd Crowther, head of client innovation at financial services technology provider Pirum Systems, says: “With outsourced technology solutions, firms can benefit from technical support, experienced client service teams, and expertise from an established provider who has extensive experience in the margin and collateral management space in terms of implementing a target operating model to achieve standardised processing, automation, workflows, and STP connectivity.”
Both buy- and sell-side firms’ quest for transparency into where their collateral is and what assets are available for margin has been accompanied by their evolving use of automation for associated processes, such as settlement, says John Straley, chief operating officer at DTCC Euroclear GlobalCollateral Ltd. “Over the next few years, the focus is going to be getting information into firms’ systems and into the right hands in a timely manner so that appropriate decisions can be made,” he points out.
EquiLend’s Oh adds: “The collateral market is growing in complexity. Firms must understand their internal drivers and be able to access, construct, connect and navigate the various routes to market. Simplifying this access has to be the industry’s goal.”
Shifting priorities and demands
Regulation is not the only issue impacting the buy-side’s approach to collateral. ESG (environmental, social, governance) is one such issue that has been under the spotlight of late, and the momentum behind it shows no sign of abating. In 2018, signatories to the Principles for Responsible Investment (PRI) were up by 21% over 2017, and according to the Global Sustainable Investment Alliance’s April 2018 Global Sustainable Investment Review, sustainable investing assets grew by 34% between 2016 and 2018.
For asset owners and asset managers engaged in securities lending, recalling and restricting securities to protect voting rights is one method by which the buy-side can align their activities with ESG principles. However, as the conversation surrounding the interaction of ESG with securities lending and borrowing picks up pace among the beneficial owner community, the question of collateral acceptability continues to garner attention. Namely, how can the buy-side ensure that the collateral they receive from borrowers is compatible with their ESG policies and how can providers assist in making this process as seamless and efficient as possible?
Bond says: “A powerful eligibility engine that provides for flexibility around rule composition can enable institutions to take comfort in the fact that they can quickly adapt to align with ESG policies.”
J.P. Morgan’s Emerson agrees that ESG is now firmly on the industry’s radar, and has particularly risen up the agenda among pension funds. “As an organisation, we are also ensuring that wherever possible ESG is a part of our product roadmap,” she continues.
ESG may place more restrictions on the collateral beneficial owners will accept, yet conversely, there has also been a drive for the buy-side to be more flexible in order to improve their attractiveness from a securities lending perspective. As Matt Wolfe, vice president of strategic planning and development at OCC (Options Clearing Corporation), states: “If a lender can differentiate themselves by being more flexible with regard to collateral, as well as things like term, it makes them a more attractive lender and they can increase their utilisation versus other lenders who are perhaps more restrictive.”
“The borrower community are constantly looking for buy-side institutions to expand their collateral offering – that includes more non-cash collateral, broadening their acceptance to include ETFs and ADRs, or additional equities indices as brokers look to finance emerging markets such as Korea and Taiwan,” says Bond.
He explains that as more borrowers run long positions in local government bonds off the back of local trading and initial margin requirements, buy-side institutions lending high quality liquid assets can gain an advantage if they are willing to be flexible around the collateral they will accept in return.
“Collateral flexibility is going to be increasingly required, due to regulatory pressures and the need for better controls,” adds Transcend CEO Bimal Kadikar. “But once buy-side firms have that flexibility, they need to make sure they have collateral visibility and the best controls in place.”
Whether it be impending regulation, ESG considerations or greater collateral flexibility, it is clear that the collateral ecosystem is becoming increasingly complex for the buy-side. “Firms need real-time monitoring and reporting capabilities, governance processes and frequent spot-checks on the collateral being received. They need automated tools to be able to do that – it all points to technology,” says Robert Frost, head of product development at Pirum Systems.
The ability to modify electronic collateral schedules in an automated way, for example, could enable buy-side firms to more easily integrate ESG policies into securities lending and collateral management programmes, notes Wolfe. He adds: “That can be difficult to manage when collateral schedules are essentially an appendix of a legal document that needs to be modified, executed by two parties, and then manually updated by the custodians – it’s a slow and inefficient process.”
This article features in the Collateral in 2020 Guide. Download the full guide here.