Buy Side Forced to Review Collateral Arrangements

Terry Flanagan

The introduction of mandatory clearing of over-the-counter derivatives is forcing the buy side to think more strategically about its use of collateral according to the Bank for International Settlements.

In a report on developments in collateral management services the BIS said sell-side firms have historically optimised collateral to settle repo and securities lending transactions and margin calls. However asset managers and pension funds had a less sophisticated approach as they tend to own high quality securities and have had fewer collateral obligations.

The report said: “However, the advent of the mandatory central clearing of OTC derivatives and its associated collateral requirements, as well as bilateral margining requirements, are forcing the buyside to think more strategically about its approach to the management and deployment of its collateral.”

The BIS interviewed 23 financial market infrastructures and large custodian banks that support global collateral management.

The report said the information on collateral obligations and available securities has traditionally been fragmented between asset classes in different locations and amongst multiple custodians.

“While some firms have worked to centralise this process over time, with large global broker-dealers being the most advanced in this respect, it is only now, with the advent of increased demands for collateral, that many other large market participants are seeing the value in making significant investments to improve their processes around collateral management,” added the BIS.

The report said developments in collateral management services are focused on improving the information inputs across locations and/or developing algorithms to generate more efficient allocation recommendations to meet relevant deadlines. These services include taking into account daily pre-agreed obligations, any intra-day changes and calls for collateral and forward-looking analysis and projections.

The BIS said: “The innovations related to the aggregation of information, optimisation and allocation of available securities for collateral management purposes are targeted at traditional customers of service providers, such as large broker-dealers, and non-traditional/potential customers from the buyside such as pension funds.”

The BIS said other innovations specifically targetting the buyside include the “quad-party” model which seeks to address segregation of collateral for market participants accessing central clearing counterparties through another clearing member.

When a trade is centrally cleared it can involve four parties – the client (indirect clearing member), the (direct) clearing member, the CCP and the client’s custodian. The quad-party model allows direct delivery of the client’s collateral to the CCP under the clearing member’s instruction rather than having to go to the clearing member first and then to the CCP.

“Innovations targeting the buyside, such as the quad-party model, add an additional layer of complexity for the custodian to the array of collateral management service offerings – in terms of the possible legal issues regarding segregation, and operational risks in managing frequent collateral movements for multiple clients,” added the BIS.

The majority of buyside firms are considering outsourcing collateral management according to a survey in June from Sapient Global Markets, which provides business and technology services for capital and commodity markets.

The Sapient Global Markets 2014 Collateral Survey found that 43% of buyside firms are currently using an external collateral manager, as outsourcing can help firms to become compliant with new regulations and reduce cost. The report also said that 70% of buyside firms are considering outsourcing as a collateral management strategy.

The BIS study found no evidence of collateral shortfalls or dislocations and said this may be because mandatory central clearing of OTC derivatives has not been introduced in all jurisdictions.

“It should also be noted that the needs of market participants may vary based on current balance sheet holdings and investment activities,” added the BIS. “For example, in some countries, pension and sovereign wealth funds already hold ample amounts of high-quality collateral relative to their derivatives activity and thus may rarely need collateral transformation services. However, in other countries, these same entity types may face collateral shortages.”

Featured image via M. Schuppich/Dollar Photo Club

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