Fintech Insights

Employing Technology to Its Full Potential

David Lewis, Senior Director, FIS

June 11, 2019

We live in an increasingly exception-based society where repetitive processes are undertaken more and more by machines or automated processes. These can range from the mundane tasks, such as washing clothes in the washing machine, to truly transformational events such as the breaking of the Enigma code in World War II. The inventor of the code breaking machine, Alun Turing, commonly referred to as the creator of modern computing, recognized that the task of breaking the nearly 159 quintillion (159 billion billion) possible combinations in each discrete 24-hour window available to them was simply beyond any human capability, instead developing a machine to meet the challenge. In more recent years, with the advent of the smart devices we all carry around or have in our home, we have seen what was previously truly transformational in terms of processing capability become almost mundane.

Industrial processes, such as vehicle manufacturing, are dominated by automated factories populated by robots. Using humans to build such products no longer makes economic sense, as global competition has increased and margins have been squeezed. Our own financial markets are seeing robot advisors providing banking services and even replacing fund managers as the “fee-free” investment fund becomes more common, and costs must be cut in an ever more complex environment. Securities finance is no different. The increasingly complex regulatory environment drives change in our own processes and structures, but it is also pushing demand for securities finance and collateral management services ever higher.

The GFF Summit in Luxembourg at the end of January produced a great deal of interesting analysis and commentary, including reporting a belief among 83 percent of attendees polled that the demand for High Quality Liquid Assets (HQLA) would either “increase” or “increase significantly” over the next two years. With only 48 percent of the same audience indicating they believed that the supply of HQLA would “increase” or “increase significantly” over the next two years, the effect on the market will not be hard to predict. In simple supply and demand logic, this will bring even greater pressure to bear on the market mechanisms charged with mobilizing collateral to meet the increasing demand.

To put this into some kind of perspective, consider the expanding influence of initial margin requirements for non-cleared derivatives. Following the Pittsburgh Summit of 2009, when the G20 Heads of State met, the Financial Stability Board (FSB) was charged with finding ways to “improve both the quantity and quality of bank collateral and to discourage leverage…” as well as mandating all standardized OTC derivatives to be centrally cleared and those outside the central counterparty system be “subject to higher capital requirements.” All laudable aims, but the task before the market and its regulators would be enormous. In 2011, for example, the OTC market had a notional outstanding value of $708 trillion, or 10 times the GDP of the world at that time. The mark-to-market value at the same time was equal to around half the GDP of the world.

As the regulation rolls out, the market will have to source new collateral to provide both initial and variation margin. The phased-in approach of the regulation commenced in September 2016 and ends in 2020, with new market participants falling within its jurisdiction as the compliance level, based on notional trades outstanding, is lowered incrementally. September 2018 saw the entry levels set at over $1.5 trillion average notional outstanding, capturing just seven of the world’s largest banks; September 2019 saw the entry level lowered to $0.75 trillion, bringing a further 35 organizations into the fold. However, the final increment will be the most transformational. In September 2020, all firms trading uncleared OTC derivatives with an average notional outstanding of over just $8 million will have to comply with the bi-lateral collateral delivery requirements. This is estimated at bringing 985 further entities into the scope of the new requirements.

Given that ISDA estimated the value of collateral requirement to be around $1.4 trillion as at September 2017, roughly equivalent to the GDP of South Korea, the effect of this rollout across so many market participants, in terms of the collateral requirements they need to satisfy, should not be underestimated. At FIS, we are seeing increasing activity from our clients looking to combine their securities financing and collateral management operations, with the objective of making the best use of all the collateral they may already have.

While looking internally rather than to the street, for ways to supplement the increasing thirst for collateral, may lessen the strain on the financing market, it does threaten to disrupt the existing transaction chain. Increasingly, large asset managers are looking to manage their own collateral needs as far as they are able, developing repo and securities lending capabilities to manage the forces of supply and demand across their own organization, before addressing the wider market. In order to manage this, increasingly complex collateral management systems are being developed, coupled with enhanced position management systems to give an overall, multi-discipline, multi-market view across the company. Standardization of contracts, such as the ISDA CSA (Credit Support Annex to the ISDA Master Agreement), will help smooth the process of calculating bilateral initial margin between counterparties, but the enormity of the task and the demands it will place on the financing industry cannot be underestimated.

The opportunity it brings cannot be underestimated either; such an increased level of demand for collateral will likely bring a significant rise in activity across the transaction chain. However, to achieve that effectively and efficiently, the industry will need ever more advanced systems and capabilities, the likes of which Alan Turing could only have dreamt. Returning to the January GFF conference, another relevant discussion demanded attention and should ring alarm bells in some quarters. A panel on emerging technologies observed that technology employed “remains well below its full potential.” Given the forthcoming demands that our market faces, the full potential of current and new technologies such as DLT and smart contracts must be employed if the market is to stay afloat, let alone develop. The latest FIS™ Readiness Report indicates 80 percent of industry leaders in banks and brokers are embracing such digital innovations and seeing results. Are you?