What are the biggest challenges your buy-side clients are facing regarding management of collateral?
Collateral managers in buy-side firms are facing unprecedented challenges from a wave of regulatory and market changes. Uncleared margin rules, MiFID II and preparations for FINRA 4210 are significantly increasing the amount of collateral required and the volume of collateral calls they have to process. I would categorize these as two major sets of problems: how to minimize the cost of the collateral that is required and how to handle the extra operational burden of the increase in volumes.
Can you explain the operational challenges and what buy-side firms can do to overcome them?
Buy-side clients are reporting massive increases in the volumes of collateral calls they have to deal with every day. Some have reported up to nine times increase. If they manage the process internally, they need to automate as much as possible. Faced with such a problem, they should take a look at the cost and value they could get from an outsource agent. Many buy-side firms are now looking again at the outsourcing strategy and deciding they can do it more efficiently in-house. The drivers here are cost savings and control over the process.
How can technology help? What do they need from a system?
The key requirements are automation, connectivity and control. They need a solution that provides a highly automated, STP collateral operations environment across all cleared and bilateral products that connects directly with CCPs, FCMs, custodians, triparty agents and market infrastructure. Our asset management clients tell us their average processing times have gone from seven minutes to ninety seconds per call through the automated workflows and direct connectivity to brokers. Available in the cloud, a lean solution offers value, simplicity and performance with the scalability to service blue-chip firms.
How do these buy-side firms know they are being asked for the right amount of collateral?
Aside from the mechanics of meeting the margin calls, we are seeing increasing requests for tools to validate the calls. Initial margin calls in particular are the focus and whilst brokers and exchanges may provide access to their calculators, they are generally clunky and difficult to integrate. To address this problem, FIS has launched a cloud-based initial margin replication service for the buy side that now offers the same levels of capability previously provided to the FCMs. This solves the problem of validation of the broker calls and also allows clients to run what-if scenarios. Forecasting IM means they can pre-fund margin accounts with securities and avoid intraday cash calls.
Can you explain the problem of cost of collateral?
Collateral is required to support a wide range of a fund manager’s trading activity. If they are hedging risk with OTC or listed derivatives, these will require collateralization. Likewise, if they are active in the securities finance markets for yield enhancement or collateral transformation, they may also face collateral requirements. The collateral itself is typically either cash or high-quality liquid assets. Holding cash for margin puts further pressure on fund performance. Managers are then forced to look for ways to minimize that overhead.
What strategies are available to minimize the cost of collateral?
There really is a three-step approach here. First pre-trade, you need to look at the full cost of doing a trade to decide where and with whom it should be placed. That means being able to calculate the margin impact of the trade prior to inception by replicating the initial margin it will attract on top of the existing portfolios. To do this best, you need to be able to simulate the new trade across all the dealers to see the margin that will be required and the funding cost of that margin based on the eligibility and haircut rules.
Second, you can take an existing portfolio of trades and look at different scenarios to see how they may be rebalanced to reduce the overall amount of collateral required while keeping the same risk profile. Also, to be able to predict what the margin requirements will be in the coming days to make sure you have the right assets in the right place to avoid intraday cash calls.
Third, you can optimize how your inventory is deployed across all your collateral and funding requirements to make sure you get the best value for it.
How can fintech address these challenges?
Buy-side firms can leverage deployed or cloud solutions to replicate the initial margin calculations of all the major exchanges and CCPs, to optimise collateral and to provide highly efficient STP collateral operations. They get the competitive advantages of being able to validate the IM calls they receive, estimate future IM calls, simulate IM for new portfolios, or stress-test existing portfolios and optimize their collateral allocations.