The Hidden Cost of Collateral

By Hervé Carrere, Vice President, Director Product Management, Finastra

Updates to uncleared margin rules (UMR) implemented in 2022 require a wider range of organisations, including large and smaller buy-side institutions, to now meet the same requirement to exchange collateral as larger sell-side market participants. These firms now need to consider collateral management as part of their trading activities. Transaction reporting is also set to become much more stringent in the coming months, with the European Markets and Infrastructure Regulation (EMIR) REFIT due to be introduced by April 2024.

Under these new regulations, any firm trading a derivatives contract will be required to report to the regulator within 24 hours, detailing not only the trade, but also the underlying collateral and the risk type of trade. Firms will therefore need to carry out detailed audits on the trades which they are reporting.

The Bank of England will be particularly interested in the movement of gilts, specifically where they are being used as collateral and why they are circulating so fast. Historically, this information has been difficult to find. With the UK regulators no longer obliged to follow EU practice, regulations around government debt reporting may be tightened further.

Companies that have previously used cash as a cheap form of collateral are now having to pay more due to higher interest rates, reducing returns. Firms taking on more risk in the search for higher returns will require considerably more collateral. The knock-on effect of this is that, for smaller, less liquid organisations, trades will become more expensive, which may lead to their taking bigger positions and putting more risk into the trade. 

In a changing world it’s easy to see how smaller firms with limited understanding of effective collateral management can incur unexpected costs: a measure designed to reduce risk has the opposite effect and a trade which initially seems profitable is anything but. Not only can this trigger the interest of regulators, who look closely at capital ratios, but it could also lead to greater risk-taking. There’s also the prospect that alternative uses of the collateral could work out more profitable than the trade in question.

What firms need

Perhaps surprisingly, many firms do not keep a real-time inventory, but take account of their assets only at the start of each day. So in the course of the trading day, they may have a general idea of their collateral, but not of movements during the day. To trade efficiently, it’s important to have access to a real-time inventory and to be able to get real-time pricing.

A particular problem in the collateral world is the quality and source of available data for accurate pricing. Although pricing agents exist, they not only add another processing stage to the transaction lifecycle, they also add cost. Access to them is restricted to Tier One firms who then benefit from the best prices, while lower tier market participants can be squeezed out.

In the evolving collateral management process, the trader’s role has changed. Their concerns are no longer confined to the trade itself, they must now consider price and collateral sources. They must understand ISDA documentation relating to counterparties and get familiar with a number of processes which have now been driven further up the trade cycle. Since any reversal here is highly unlikely, visibility of this information is now key to the trader’s role.

Managing collateral effectively will give firms much finer control over the trades sitting on their book. While the process of creating a comprehensive collateral management solution is not without challenges, the following five elements are key:

1. Optimise data quality

Good quality data is essential. The more recent that data is, the better. The world of financial technology is gradually transitioning to ‘real‑time’. And given the explosive growth of data, sourcing, validating and interpreting that data in real-time is a significant undertaking for any legacy infrastructure. Furthermore, multiple data sources are now preferred. This data then requires validation and scrubbing to remove errors and ensure consistency before any reliable interpretation can begin.

1. Understand system limitations

Data interpretation and analysis can take place in one or several of a whole network of systems. One problem faced by many organisations is dislocated systems and silo-based functions that communicate poorly with each other. Implementing integrated systems for the management of collateral is one of the biggest challenges facing firms as new regulations come into play. Problems also arise when organisations rely on batch-based processes. With three or four batch runs in the course of a day, crucial trading information may be unavailable for periods of time.

Organisations with batch-based systems must learn to mitigate this risk, either by making batch runs more efficient or by cutting their cloth to suit their budget. They need to understand their limitations for large and important trades.

1. Get sight of your overall position

It’s important for a trader to be able to see their entire position rather than just cash or securities, in real-time, and to be able to take a view of the trading horizon over the next four to five days.

1. Think like a risk manager

It’s essential that traders understand not only the risk of each trade but also the underlying collateral, what it is and how it is priced. An understanding of the documentation is also essential – what would happen if the trade failed for a day or longer? What would happen in the case of bankruptcy? A typical collateral agreement should also detail the acceptable collateral, frequency of margin calls, haircuts, threshold level, close‑out and termination clauses, valuation and rehypothecation.

1. Keep an open dialogue with counterparties

Counterparty communications is an essential part of collateral management. Accurate and timely communication can vastly reduce the number of disputes relating to margin calls, collateral exposure and collateral evaluation. There are often ways to mitigate problems, such as offsetting the trade against others or using a clearing mechanism which, although more expensive, will guarantee settlement of the transaction.

The importance of technology in managing collateral efficiently

Many financial institutions are reviewing their solutions for collateral management due to changing market conditions and regulatory compliance requirements. Effective collateral management should consist of co‑ordinated organisational structures, processes and methodologies alongside robust technology.

As real‑time data processing capabilities help traders establish a competitive edge, the expense of such technology should diminish. Automation is becoming increasingly important in the optimisation of collateral management. The separate operational tasks in the collateral management lifecycle, such as data collection and validation, margin calculation, margin call workflow, collateral reporting and inventory management can all be automated. This reduces both operating costs and the incidence of error.

Successful collateral management requires diverse capabilities in the areas of operations, risk management, custody, settlement and legal documentation, with open and frequent communication between partners inside and outside the organisation.

A single solution covering all aspects of collateral management simply does not exist, so don’t waste time pursuing one. Skilled resources working in harmony, using interoperable systems will be the key to optimal collateral management.

With new regulations pushing the market to make better use of collateral, working with a trusted technology provider, like Finastra, that offers a range of solutions and connectivity to tri‑party agents, third party custodians and settlement service providers can make collateral management easier for both banks and individual buy-side firms.

The pace of change in today’s financial markets requires firms to commit to continuous innovation and sophistication in order to maintain a competitive edge. Integrated and well-run collateral management processes not only benefit individual firms, but also enable operational risk and market risk mitigation for the market as a whole.