Collateral management reform could herald benefits for risk managers

July 30, 2012

By Rachel Wolcott

LONDON/NEW YORK, July 30 (Thomson Reuters Accelus) – Risk managers could benefit from the financial services industry’s revamp of collateral management services in preparation for the new regulatory requirements that will drive demand for high-quality collateral. New regulations for the clearing of over-the-counter (OTC) derivatives through central counterparties (CCPs) alone could increase demand for high-quality collateral to $2 trillion or more, according to some estimates. In response, some firms are aiming for a more universal approach to collateral management.

Many firms still take a rather old-fashioned view of collateral management. It is often fragmented and inefficient. Most firms operate collateral management in silos determined by geography or asset class. This can lead to poor communication between different collateral management functions — for example, repo staff might not speak to the securities lending unit, or the New York office might not speak to its UK counterpart as much or as often as it should. What banks have realised is that these inefficiencies must be addressed to meet coming demand for collateral management services. Banks have also realised that, in a world economy, where there are limited opportunities for business growth, effective and efficient collateral management could be a money spinner.

“Banks are taking this as a new area of focus to improve efficiency. They are breaking down walls and going from having 16 pots of assets that are not connected in anyway to trying to get to one pot of assets — even if it’s virtual — to see the entire universe of what they have on the supply and demand side in one spot. That clearly enables them to take advantage of more business opportunities,” said Stephen Vinnicombe, partner and UK finance, risk and compliance lead at Capco.

Risk management benefits

Knocking together these pots of assets and breaking down asset-class and geographic business silos could be a boon to risk managers too. One of the challenges flagged up by the financial crisis was banks’ inability to get a complete view of their risk profile on an aggregated basis. Indeed, some technology vendors and risk management consultants have tried to talk up the potential for firms to develop systems that provide them with a single view of risk.

That could be in the form of a ‘dashboard’, which would give some kind of aggregate reading of a firm’s risk positions. So far that has not materialised, but this efficiency drive in collateral management might push some banks closer to having a firm-wide view of risk.

“There is potential to use the breaking down of silos to optimise your collateral management to help with your monitoring and measuring and modelling some of the risks that are involved in the core trading businesses and strategies where collateral is received. That will be a cross-asset view where your risk management teams will begin to better understand what the risks are between the different businesses and how collateral can be used to offset some of those risks,” said Eric Bystrom, a principal consultant at Capco.

“It’s not just credit risk; it’s also liquidity risk and funding risks and other risks as well. That is not an accidental coincidence by the risk departments. They are big sponsors internally of some of the internal projects to patch together these silos simply because they’re aware of the opportunity to get a better view of their risk positions,” he said.

It is possible, then, that the same pressures and drivers that banks’ collateral management businesses are responding to will push them toward a holistic view of risk management. And, because of increased capital requirements and other regulations, bankers have less cash to trade with, so having an improved and more sophisticated overview of risk management could allow them to make better-informed business decisions.

Moving to a more comprehensive view of risk could allow banks to better assess the risks involved in transactions and the potential capital charges, as well as the potential rates of return in the new global regulatory regime.

Cost savings and business opportunities

As the U.S.’s Office of the Comptroller of the Currency warned in a report published on July 5, some American banks may be taking excessive risks to increase profits during these times of difficult trading. Indeed, banks have to scratch around to make money, and collateral management is one area coming under scrutiny. It is not just a case of meeting the great demand for collateral to post against OTC derivatives trades. Firms want collateral managers to help manage their own funding needs more efficiently and produce cost savings.

A recent paper from Accenture’s collateral management services group said: “[The] implementation of global regulations such as Basel III, the Dodd-Frank Wall Street Reform & Consumer Protection Act and EMIR/MiFID II] will bring increased capital and reporting requirements that squeeze operating margins, while collateral managers are increasingly being required to become active participants in their firm’s profitability and pricing strategies … These drivers will finally take down the walls between investment banking departments, and will force unprecedented synergies across operations for cash-settled securities and OTC derivatives. Services and information models will converge, enabling better cost management and capacity that expands or contracts along with business demand.”

Vinnicombe said: “Generally banks are a bit stuck for ways to make money. They are looking at efficiency, which is: ‘are we using the money we have in the most efficient way?’ The conclusion has been to look at the collateral management and funding internally. Historically that’s been done on an asset-class-by-asset-class basis by the big banks. There have been business cases that have been put together that are quoting hundreds of millions of dollars per year, either saved cost in terms of funding costs or new revenue in terms of better rehypothecation of the assets they have by centralisation, knocking together the silos and doing funding once across the bank.”

Not many banks are at the point where they can boast being able to do funding on a firm-wide basis. Goldman Sachs and Morgan Stanley are said to be leading the market in this respect, but most other banks have considerable work to do.

Supply and demand matching

Already the industry’s big players in collateral management are seeking to improve their offering in response to regulatory changes. BNY Mellon has been one of the first to announce a new approach, with its global collateral services unit. The U.S. firm recently said it will bring its existing capabilities in segregating, allocating, finance and transforming collateral under the global collateral services banner.

“Each one of the constituents in the market place is going to have different drivers around the economics of posting collateral and the type of collateral. We’re helping our clients do the best job from an economic and risk standpoint to put to work the collateral they have against the obligations they have in the market place,” Kurt Woetzel, head of global collateral services at BNY Mellon told Thomson Reuters.

Firms such as BNY Mellon and JPMorgan, which have always been big players in the custody and collateral management businesses, should be well positioned to marry clients in need of collateral with those able to make it available. JPMorgan, for example, has roughly $16 trillion in assets in custody, which gives it a big data window showing who has the collateral other clients will so desperately need.

“Hypothetically if you set up a very efficient supply and demand matching across that asset base you could be the facilitator for an awful lot of the business of searching out high-grade collateral,” Vinnicombe said.

Banks are not the only ones stepping up their collateral management offerings. Other kinds of firms, such as exchanges, clearing houses and securities depositories are vying for a piece of this growing business segment. For example, Euroclear, which settles securities transactions of all kinds, is trying to create a collateral highway. That is a service Euroclear hopes will be the first global market infrastructure to source and move collateral where and when it is needed.

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. <a href=” ions/regulatory-intelligence/compliance- complete/” target=_new”>Compliance Complete</a> provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 230 regulators and exchanges.)

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