After cracks developed in global financial markets post-crisis, regulators embarked on sweeping reforms to the OTC derivatives world. The $630 trillion notional OTC derivatives market has been impacted by regulations such as Dodd-Frank in the US, EMIR in Europe and Basel III globally. Implementation means a major shake-up in how derivatives are settled, collateralised and reported.
Grigorios Papamanousakis, Quantitative Strategist, Aberdeen Asset Management
Consequently, the once obscure world of collateral management is being thrust into the spotlight.
For portfolio managers, there are two main concerns: the amount of liquidity required in the portfolio to post collateral to counterparties; and the amount of cash needed in order to face a client's liquidation.
This may sound simple. But when the marching orders are to optimise capital as efficiently as possible, the amount of computation required is actually quite complex.
As a result, more and more quants are coming into the space.
Moreover, standard computers can't be expected to keep with the billions of calculations that need to get made."The more collateral management transforms to a front office procedure, the more front office quants will be required," said Grigorios Papamanousakis, a quantitative strategist at Aberdeen Asset Management.
Making the right decision can have a big impact on the bottom line in a capital constrained world. Instead of posting cash directly, for example, it might make sense to get bonds via repo markets, even with the additional haircuts.
Presenting at the Alphascope conference earlier this year, Papamanousakis demonstrated using a hypothetical example how making different decisions on the order of posting collateral among varying tiers of haircuts (cash, UK government bonds, AAA bonds, high yield bonds) could mean a difference of many millions of pounds.
Source: Aberdeen Asset Management
"From the moment you have to add bonds into your portfolio as collateral, you have to monitor the credit risk of the bond - the credit quality - because if it downgrades or upgrades, that means you have to take it back or post additional haircut," he said.
Then there's decisions to be made about more complex collateral products, like credit default swaps or MBSs (mortgage-backed securities).
"The daily valuation is more complicated and more difficult to monitor," said Papamanousakis. "Computational impact increases exponentially when you add non-cash collateral, because we have to monitor and optimise the portfolio based on the credit quality of the bonds."
The moment that the first non-cash collateral has been posted from either party, he added, there's a need to start simulating the credit migration risk associated with that bond. And the same applies to equities.
The computational intensive exercise involved in modelling the best scenarios is "ideal" for parallelisation and acceleration using high performance computing, added Papamanousakis.
That includes: multicore processors, FPGAs, or cloud environments. A case study using GPUs shows acceleration of between 24 and 40 times depending on the number of scenarios. Instead of taking two hours to complete calculations, it takes four minutes.
Source: Aberdeen Asset Management
"The dynamic portfolio grows the computational complexity exponentially, and high performance computing is essential but you have to consider three things," he said. "The total cost of ownership, the business case we have, because the solutions are different, and in-house development has a significant (personnel) risk - you could invest three years to build something and then be unable to support it. So maybe the decision is to outsource."
An indication of when an outsourcing strategy should be considered tracked against Assets under Management and the number of agreements. Source: Sapient Global Markets
Consultancy firm Catalyst Development, has a front row seat on how the changing dynamics of regulation are affecting the collateral management world.
Stephen Loosley, Partner, Catalyst Development
Stephen Loosley, partner at Catalyst, said that clients need advice on how the market infrastructure landscape is changing and what regulators would require of them, as well as vendor selection and front office integration of workflow.
"What we really do is basically look at how regulation changes the way collateral influences the real cost of trading," he added.
Meanwhile, firms are trying to anticipate the approaching, still uncertain, regulations - MiFID II and MiFIR - in Europe affecting collateral application.
"One of the challenges firms face is how to understand the cost of trading for them to be able to put a price on the Organised Trading Facility (OTF), and how to guarantee certainty of clearing the pre-trade in terms of collateral check-in and workflow back through the different pieces of market infrastructure to the CCP for a cleared trade," he said.
While regulators are focusing on how much margin is required, Loosley feels that the real issue at hand is collateral velocity and fluidity of collateral. In other words, how quickly can it be moved?
Every day collateral management becomes more sophisticated, said SunGard's head of product management for collateral, Ted Allen. And firms like SunGard have to constantly innovate to keep business coming in.
Products have gone past outsourcing IT functions, to include operations process and supply chain finance. Barclays was the first client for a new utility combining these aspects, and SunGard will be taking on the bank's back office functions - which means IT infrastructure and staff will be transferred over.
Ted Allen, Head of Product Management for Collateral, SunGard
Allen expects to see a demand for tools that help minimise costs
of posting collateral. In pre-trade, optimisation will likely
require applications that calculate the varying implications of
trading with different counterparties.
"Capital is becoming a scarce commodity and there needs to be closer understanding of trading activities," he said.The future, Allen said, will be the further push of collateral into risk and treasury management, while collateral terms will get incorporated into treasury decisions for how capital gets allocated.
"There is ongoing optimisation on whether it makes sense to close out some trades, to purchase hedging transactions, to reduce overall portfolio requirement or to backload the collateral trade onto a centrally cleared model," he said. "Post-trade optimisation deals with the allocation of collateral to minimise funding cost of collateral and balance sheet impact."
Back to front
According to a survey from Deloitte, a large majority of respondents (80%) said that collateral management teams report to front end or treasury managers. The reason was simple: these teams weren't just managing collateral, they were optimising its usage and so were actually a cost centre and therefore, vital to operations.
"Traditionally, collateral management has been defined as a back office operation - it was a routine job, in a forgotten corner of the back office," said David Little, director of strategy and business development at software provider Calypso Technology.
It was perceived to be an overhead in the post-trade world, as "everything interesting was only happening in the front office". But with the level of complexity involved with optimising collateral today, that perception is changing.
Some 39% of banks, buy side firms, CCPs and custodians in North America and Europe want to turn collateral management into a profit centre for generating additional revenue, according to a recent survey from Sapient Global Markets.
David Little, Director of Strategy and Business Development, Calypso Technology
Little said that the primary outsourcing drivers are increased margin calls, and custodians stepping up with offerings. But there has been a reversal trend too.
"(Firms) have begun to see that collateral has become too important for them to leave to outsourcing. They now need closer governance and oversight of what the outsourcers are doing on their behalf," he said.
Part of that is the need to have information made available to asset managers at all times. "Due to the increased number of margin call requirements, the firms have to justify their operations, so it would be easier to bring the entire activity back in," said Little.
Before collateral can be effectively managed, it needs to be settled in a way that avoids conflict.
TriOptima is one of the portfolio reconciliation platforms, whose service triResolve reconciles some 75% of all non-cleared OTC derivative transactions globally across 1,400+ firms.
"People have been keen to understand and align their exposures with their counterparties, especially after the Lehman Brothers collapse in 2008," said David White, product marketing manager at TriOptima (London).
Regulations are a big part of the equation. The CFTC, under Dodd-Frank in the US, and ESMA, under EMIR, implemented portfolio reconciliation requirements that became mandatory in 2013.
"We saw a lot of people sign up for our portfolio reconciliation services not just because it was good business practice, but also a regulatory requirement," he added.
The foundation of ensuring collateral optimisation is to ensure that collateral calculations are consistent between counterparties. Comparing trade details and trade valuations is critical.
"With the volume of trades, the dynamic trading environment and differences in yield curves and valuation methodologies, it is inevitable that there will be discrepancies," White added.
David White, Product Marketing Manager, TriOptima
The rise and fall of Project Colin
It's hardly surprising that the financial services industry has a hard time agreeing on disputes, or that initiatives at the forefront of aiming to fix this run into the ground.
Almost as quickly as word started to spread about the top secret attempt by Goldman Sachs to tackle the emerging world of collateral management, there was trouble.
The utility was intended to manage disputes, and generate and agree margin calls. But little has been heard since media reports announced that the project's architect, Paul Christensen, Goldman Sachs' co-head of Principal Strategic Investments (a team leading the collateral utility's development) was set to leave the bank.
In the new world of collateral, every bank will have to build a margin dispute process, as well as initial and variation margining facilities. Although there is headway in doing that for the cleared world, the uncleared derivatives universe has yet to find a standardised solution.
The buy side has a bit of leeway, but it's coming for them as well, said David Field, founder of consultancy firm, The Field Effect. Without a central utility, it will be every firm for itself.
Margin disputes will be very expensive for non-cleared OTC, and the industry wants a centralised solution for calculation and reconciliation. There is a "network effect" from having a utility around dispute management, said Field.
In other words, the more firms use the utility, the easier it gets for everyone.
Agreeing margin with a counterparty has several challenges to overcome, not least of which is first agreeing a model to calculate initial margin. Regulators have offered up the standard schedule model - a measurement using a percentage of a firm's OTC notional outstanding.
"That is a very crude method that generates large numbers that nobody wants to use," he said. "The industry desperately needs to create an alternative, more finely-tuned margin model."
ISDA is working on a Standard Industry Margin Model, but it seems that the gap is wide enough for more players to come forward, and he pointed to service providers such as NetOTC.
Although a clear picture of what derivatives trading will look like once regulations are settled is yet to emerge, it seems there will be plenty of opportunities for those focusing a lens on collateral management in the landscape.