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Date Created: 09/20/15
kman uZgtZngt mOmltltgtm ltltImugtum 00rrgtmgt OugtgtmgtOZ Z gt OmZgtlt rmgtmu ltltOU DEQIA 1ZgtZngt m01ltltgtm 4sight Whitepaper Collateral Optimisation in a Centrally Cleared World Introduction Collateral management has been used for hundreds of years as a powerful tool for managing risk This is its primary and most important purpose However following the upheaval of the financial crisis and the default of a large interconnected broker when Lehman Brothers collapsed there has been a seismic shift in the evolution of the collateral management process Postcrisis we have seen advances in collateral management follow two distinct but interconnected routes Route 1 More effective risk management The first path centres around more effective risk management Firms are starting to use far more sophisticated methods to monitor and control counterparty credit risk This includes giving more thought to the likelihood a counterparty will default It also involves a greater consideration of how easy it is to liquidate collateral in the event of a default Firms are now applying increasingly complex collateral eligibility concentration and haircut rules to mitigate these risks and implementing technology systems to support this Route 2 Cost reduction The second evolutionary branch in the collateral management story is around collateral optimisation This has seen collateral management diverge into a cost reduction exercise Due to a squeeze on high quality collateral firms are now seeking to manage the flow of collateral and its balance sheet utilisation in a more efficient way It is collateral optimisation that this paper will focus on It will discuss what optimisation actually is what is driving it techniques to optimise collateral and how these techniques are helping firms adapt to a centrally cleared world 4sight Whitepaper Collateral Optimisation in a Centrally Cleared World is Collateral Cip rit TIiSG fiCmg Some dittering definitions of collateral optimisation include quotGiving each counterparty the cheapest to deliver collateral that meets their acceptability guide linesquot quotMaking the best use of inventory across the entire firm to satisfy all collateral requirementsquot quotManaging collateral supply and demand on an enterprisewide basis in the most efficient manner possiblequot At 4sight we see collateral optimisation as centralising collateral management and optimisation into a profit Treasury Derivatives centre or collateral hub39 This allows firms to keep a tight control of exposure I culllateylral and collateral usage costs on an enterprisewide Huh basis across all business lines From there firms can I make best use of collateral inventory across a number of ditlerent trading opportunities to reduce costs and I ie generate a greater return on economic capital thmstian s undue to Trm While these definitions shed some light on the optimisation process the exact nature of optimisation depends on the unique strategy and business model of each firm Goals of optimisation vary tor each company as do the cost savings that are possible This is largely dependent on factors such as o The size of the business Products traded Geographical tootprint Volumes processed Risk protile Growth strategy Sophistication in counterparty credit risllt Ability to centralise product silos securities lending repo derivatives etc Because of these factors technology proiects tor optimisation typically involve a high level of process mapping and development of custom algorithms for each firm There is no one size tits all39 approach to optimisation Technology vendors must be flexible in accommodating client needs rather than offering a generic otttheshelt solution 4sight Whitepaper Collateral Optimisation in a Centrally Cleared World Collateral allocation still involves a human decision based on common sense While technology solutions can perform complex calculations and automate many manual processes collateral allocation still involves subjective decisions There are many factors affecting the optimum use of collateral There are also competing demands for collateral between desks Derivatives Securities Lending Repo Treasury etc with widely varying strategies and objectives To solve this it can be beneficial to assign a designated department or individual with responsibility for overseeing the entire collateral function across the firm and making decisions on how scarce resources are allocated This means allocation can be more objective based on the most profitable economic return and the opportunity costs of a given deployment of assets rather than political conflicts between different business units and strategies What is Driving Collateral Optimisation Both supply and demand side factors are interacting to create a liquidity squeeze as collateral supply dwindles while demand for high quality collateral simultaneously increases There are wildly varying estimates of the exact size of the liquidity shortage that will result from this Some calculations predict that a severe shortage of highly rated assets is on the horizon while others suggest the impact on global liquidity may not be quite so dramatic However it is clear that collateral will become more expensive to some extent and collateral optimisation is therefore an important strategy that can help firms adapt to the new environment Supply side factors The poor fiscal position of many governments particularly in the Eurozone is leading to rating downgrades for many sovereign bonds Before the crisis government debt of these countries was AAA rated resulting in a large supply of high quality collateral Until recently collateral was therefore relatively inexpensive and easy for trading desks to obtain However the International Monetary Fund recently predicted that sovereign downgrades will reduce the supply of general collateral by approximately 9 trillion by 2016 This is a significant shortfall When combined with a sharp increase in demand for collateral it could lead to a considerable shortage of quality assets 4sight Whitepaper Collateral Optimisation in a Centrally Cleared World Demand side factors There are a number of factors affecting demand for collateral including o Initial and variation margin required by CCPs for derivatives trades o Contributions to CCP default funds o Reduced netting capabilities from CCP product fragmentation compared with bilateral netting opportunities o Basel III capital requirements requiring banks to hold more liquid assets o More segregation of assets required by EMIR Dodd Frank Basel CommitteeIOSCO etc o Less rehypothecation o Drying up of unsecured funding leading to more collateralised trades o More stringent regulations around collateral for bilateral trades Who Can Benefit from Collateral Optimisation Sell side Firms processing high volumes of trades and collateral movements clearly stand to benefit most from optimisation The combined effects of a large number of even small incremental reductions in the cost of collateral for each trade can result in a significant boost to the bottom line Large sell side firms processing many trades across multiple products can therefore gain the greatest ROI on collateral optimisation However it is still possible for smaller institutions to achieve measurable cost savings from optimisation Buy side In the past many buy side firms required very little focus on collateral management and put minimal investment into technology systems and processes However out of necessity market and regulatory change is forcing the buy side to invest in collateral management and optimisation Central clearing for OTC derivatives trades wiII compel buy side firms to pledge more cash and highly rated sovereign bonds to meet margin requirements for their derivatives trades This is not particularly palatable for the buy side as it causes problems for their asset allocation preferences and creates a drag on returns Collateral transformation services are therefore being offered to the buy side to upgrade lower quality assets into CCP eligible collateral for a fee However depending on the economics of upgrade trades this may be an expensive option for many on the buy side 4sight Whitepaper Collateral Optimisation in a Centrally Cleared Werld Buy side tirms are theretore coming to the realisation that collateral optimisation is an important part ot the toolkit tor reducing the pain ot collateral shortages This can range trom pledging the cheapest to deliver collateral tor each trade to more sophisticated allocation decisions on which trades are least expensive based on the collateral cost netting capabilities eligibility criteria ot a given counterparty etc The cost savings that can be achieved trom optimisation may easily outweigh the investment in technology and resources required to streamline collateral usage tor many buy side tirms What Technques can be useal to Optmise Coaterdlg Collateral optimisation is still in its intancy and there are varying degrees ot sophistication to the optimisation process Some optimisation techniques are also still taking shape due to a lack ot clarity around new regulations It is theretore doubttul it even the most torwardthinllting tirms are currently applying all ot the more advanced optimisation methods However it is usetul to imagine a possible tuture model ot collateral optimisation that almost pertectly balances the supply and demand tor collateral with sound risk management and minimal impact on balance sheet The diagram below shows a range ot optimisation techniques It moves through the basic building blocks ot simple optimisation to more advanced optimisation requiring complex algorithms and more sophisticated processing c dvanced eptmisaton 39 Cross techniques Product Adva nced netting A What if scenario analysis Pretrade Potential Future Exposure Best execution decision support Bilateral vs Triparty vs CCP which CCP Reallocation and substitution Optimise across all counterparties and products Centralise assets across business lines 4sight Whitepaper Collateral Optimisation in a Centrally Cleared World As already discussed there is no one size fits all approach to optimisation Firms can simply select individual elements that meet their specific needs as they move up the value chain There is also no prescribed order in which one needs to implement the steps illustrated above However some elements must naturally precede others before it is possible to reach the next stage Building Blocks of Optimisation Before collateral optimisation can occur a number of important first steps must take place to build the basic framework required Assigning costs to collateral assets The first step is to assign a cost to all assets used as collateral This involves assigning a funding spread where appropriate using standard market overnight or term reference rates such as SoniaEonia Fed Funds Libor etc Alternatively you can create and assign bespoke internal benchmark rates You can then use these rates to calculate and attribute collateral costs across all traded asset classes This allows you to allocate collateral costs at underlying trade strategy and trading desk level and reward internal providers of collateral whether trading inventory hedge assets or inbound collateral received that is rehypothecated Mapping eligibility criteria To pledge the optimum assets that meet acceptability guidelines it is essential to map your counterparties39 collateral eligibility concentration and haircut criteria It is possible to achieve this by electronic download and mapping of each prevailing legal contract via an inbound feed or manual inputupdating of records if required This allows you to update each clientcounterparty profile for core eligibility criteria as required Basic Optimisation Basic optimisation post lcheapest to deliver39 for a single counterparly Once collateral has been assigned a cost and acceptability rulesets established you can then carry out basic optimisation This means giving out the cheapest to deliver collateral that each individual counterparty will accept Although it can generate cost savings this model does not make use of the entire pool of assets available as collateral across the firm in a consolidated way 4sight Whitepaper Collateral Optimisation in a Centrally Cleared World EnterpriseWide Optimisation Centralising collateral across business lines The next stage in achieving optimisation is to centralise collateral assets across all business lines your firm is engaged in to form the collateral 39hub39 Inventory feeds from a multitude of sources are loaded into the collateral management system and organised into a company and book hierarchy structure This allows you to view exposures at any level for example at custodian sub custodian account level or even the dividend entitlement level Furthermore centralisation gives risk managers a far more holistic view of exposures and risk across the firm It is possible to see the firm39s real time total exposure figure across all products and counterparties in one system You can also view exposure with each individual counterparty across all traded products securities loans repo derivatives etc making it easier to comply with single counterparty exposure limits proposed in new regulations such as Dodd Frank Finally centralisation provides the foundation for netting exposures across different product lines Cross product optimisation Centralisation enables the formation of a single collateral pool across all asset classes When looking at their inventory traders can see all available assets at every level of the firm in real time This provides the information needed to make optimal use of available inventory for collateral financing It also allows better utilisation of internal assets Before going to the street to find expensive collateral to meet a margin call you can see all available long inventory held by your firm You can also make decisions on whether a security is best deployed in say a securities loan or as collateral on a derivative trade based on its collateral cost and the respective PampL it can generate 4sight Whitepaper Collateral Optimisation in a Centrally Cleared World More Complex Optimisation Techniques Optimise allocations to all counterparties across the entire collateral portfolio Centralisation of the collateral function paves the way for full optimisation across all counterparties for the entire collateral portfolio This means the collateral management system can analyse the portfolio holistically across all asset classes and then propose the cheapest to deliver for all counterpa rties Reallocation and substitution Once the optimum collateral is pledged across all counterparties and clients the next stage of the optimisation process involves regular checks of the portfolio The collateral system can then reallocate collateral on a daily or intraday basis in response to market changes Upon performing the reallocation sweep the collateral system will then automatically carry out substitutions to bring the portfolio back into line with the most optimum allocations This is a balancing act between achieving the lowest cost of collateral and reducing the number of movements required Most counterparties will not be happy if you are constantly substituting assets and settlement costs must also be taken into account Optimisation is therefore about achieving the best practical allocation rather than the best possible Best execution decision support Collateral management systems can help traders to make best execution decisions based on the economics of a given trade This includes data on the least expensive settlement location to route a trade for example a bilateral trade vs triparty vs trading via CCP It can also help decide which CCPClearing Broker to trade with for a given transaction These can be complex calculations that must take into account each CCP39s collateral acceptability and margining methodologies along with portfolio netting and offsetting capabilities It must also incorporate the regulatory risk weighting of executing a trade bilaterally vs a CCP At the time of writing exact technical standards for bilateral margining have not yet been finalised by regulators This means that a full comparison of bilateral trading vs central clearing under the new regulatory regime is not yet possible Potential future exposure calculations Finally collateral management systems will allow users to forecast exposure scenarios and resulting margin requirements through the lifespan of a given trade more accurately This involves calculating Potential Future Exposure figures by running Monte Carlo simulations to gain a snapshot of the possible margin requirements through the life of a trade Traders can then price this into the funding cost of collateral and predicted PampL pretrade This allows more informed decisions on which trades will be most profitable 4sight Whitepaper Collateral Optimisation in a Centrally Cleared World What if scenario analysis While not strictly related to optimising the collateral portfolio from a cost point of view scenario analysis can be useful for optimising from a risk perspective This allows the collateral management system to generate real time what if scenarios and stress test the entire collateral pool as market conditions change You can see the effects of movements in market prices exchange rates ratings etc and then analyse the impact this has on the collateral held and available It also allows you to shock39 the collateral portfolio by modelling the effects of black swan39 events on the balance sheet Cross product netting While technology systems currently support netting of exposures across products full cross product netting is not yet prevalent in the market Nonstandardisation of legal agreements for derivatives and securities lendingrepo is therefore holding back some of the potential netting benefits across products What are the Benefits of Optimisation Collateral optimisation offers significant benefits for financial firms of all sizes seeking to respond more smoothly to a world of collateral shortages It is true that optimisation requires upfront costs to modify procedures centralise inventory across desks and invest in technology However the cost savings of successful optimisation can generate a measurable return on investment With new regulations looming and collateral in increasingly short supply optimisation is rapidly becoming a necessity Key benefits o Manage collateral supply and demand more efficiently o Highlight collateral shortfalls o Avoid overcollateralisation o Easily identify surplus collateral sitting idle o Free up valuable liquidity o Accept a wider range of collateral o Gain clear figures for both actual and your optimal collateral costs o See discrepancies between the collateral you receive and what you can pledge o Forecast collateral requirements more accurately o Comply with regulatory requirements and reporting more easily o lvlake best execution decisions on cost of bilateral vs Triparty vs CCP vs which CCP o Enhance customer service and offer more competitive customer pricing 10 4sight Whitepaper Collateral Optimisation in a Centrally Cleared World Build or Buy Reasons to use a Vendor Solution for Optimisation lvlany financial firms are using legacy solutions for managing collateral ranging from simple spreadsheets to more complex systems developed in house However there are a number of reasons why using a vendor solution for collateral management and optimisation can be more effective The vast scope of regulatory change currently facing the industry makes it hard to build and maintain inhouse systems that are fit for purpose Monitoring new rules and rapidly building technology support requires greater resources and increased headcount Furthermore the collateral technology arms race is now moving too fast to keep up without deploying significant investment in software solutions to maintain competitive advantage Using a vendor solution ensures that firms can benefit from the most advanced optimisation tools available on the market Vendor systems can also include enhancements and new algorithms requested by other customers of the technology provider This shared approach keeps development costs to a minimum compared with building new algorithms inhouse There are also significant benefits to replacing multiple legacy systems with a single unified solution that supports securities lending repo and derivatives collateral management in one place It allows more standardization of processes across products can reduce software maintenance fees and offers the advantage of dealing with one vendor for product support It is therefore important to ensure the technology vendor selected can offer a solution with the necessary depth of securities lending repo and derivatives functionality Systems with a strong trading and inventory management function across these products as well as margining capabilities are also essential 11 4sight Whitepaper Collateral Optimisation in a Centrally Cleared World About 4sight Financial Software 4sight Financial Software is an independent software solutions provider with sixteen years of experience and offices and clients worldwide 4sight39s customer base includes a full spectrum of buy and sell side market participants from smaller banks and asset managers through to global broker dealers Clients in sixteen countries on four continents use 4sight39s software to meet their business needs and 4sight offers the reliability and experience of a company with a proven trackrecord The 4sight Xpose Collateral Management system provides an enterprisewide crossproduct collateral management solution for securities lending repo and OTCexchangetraded derivatives collateral 4sight39s product range also includes solutions for securities finance settlement and market connectivity In addition to software development 4sight provides proiect management consultancy services and customer support through its global network of offices 4sight was recently voted winner of the Collateral Management System category by its customers in the 2012 Global InvestorISF Magazine Equity Lending Awards 1 Citll lt l l Milwagcmcnt l b li f EggsIranquot WEMTIEJ 4sight 201 For further details please visit www4siahtcom About the Author Martin Seagroatt is Head of Global Marketing for 4sight Financial Software He ioined 4sight in 2005 after previously working as a business expert in technology systems for risk management in the energy industry In his 7 years at 4sight he has specialised in Securities Lending Repo and OTCListed Derivatives collateral management To contact Martin you can email him at ms4sightcom 4sight Financial SoftWare Email info4sightcom www4sightcom Fl N A N C l A L S O F T W A R E 4sight Financial Software Ltd 2012 12
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