Moving forward with the new rules for collateral management

Though widely reported as primarily a credit risk problem, one could argue that recent events were largely an operational risk problem. Stressed market environments led to breakdowns in operations, such as failure to make collateral calls, trade input errors, and inaccurate valuations all of which can create significant financial losses as well as damaged reputations. Outdated processes for dealing with the credit risk ultimately led to the liquidity risk problem. As a result, both the buy side and the sell side are revisiting their risk infrastructures, many of which were designed to avoid losses, not necessarily improve operations. At the top of the list of improvements is the ability to better assess risk drivers, to calculate the amount of portfolio at risk, and to improve overall collateral management.

The complexity of CDOs (collateralised debt obligations) exacerbated the ensuing liquidity crunch. In response, parties are calling for a return to basics, or at the very least a move toward debt instruments that are more transparent and easier to value. The credit crunch has forced collateral managers to focus on ensuring that all collateral calls are met in full and in a timely fashion. As a result, collateral managers are cautious about taking any assets that they might not be able to value and sell easily, later on, if necessary. This leads to a stronger focus on both the regularity and the integrity of the portfolio management process. With many Tier I firms feeling the pinch from this credit crunch, greater emphasis needs to be put on ensuring all discrepancies are resolved quickly and efficiently.

Collateral management at a crossroads: back to basics or a taste for the exotic?

Not surprisingly, the initial reaction to the credit crisis has been a call for a return to basics by reducing leverage and demanding more security. In the near term, there will be a big premium on tighter credit standards and collateralised trading will face increased pressure for less risky assets. Banks will lend more responsibly and more closely monitor the risk and more actively manage it.

On the other hand, once a new world order has been established, the return to basics can only be temporary. There will be a return of confidence and with it will come traders’ desire to expand trading opportunities with instruments that are more exotic. This can only be compounded by the increasing worldwide competition in the derivatives business and the growth in the number of types of companies involved in trading. As ISDA reports in its recent Operations Benchmarking Survey, the number of margin calls nearly doubled and the required collateral per call increased significantly year over year. This growth rate has created a domino effect catapulting collateral management to a “business critical” function in the trading process and intensifying the need for collateral management beyond the OTC world.

Given the likelihood for high volume and higher-risk collateralised relationships, it becomes even more important to take full advantage of technology and best practices to manage the more complex products in a controlled manner. Unfortunately, monitoring collateralised transactions for the most part has been a manual and error-prone process that places constraints on any significant growth in transaction volumes. Too many financial institutions are heavily reliant upon manual processes. It can take as much as a day to price, book and confirm collateral for collateralised transactions. Today’s enterprise-wide collateral management solutions are a reliable means to streamline the operational process, to minimise operational risk, and reduce cost. The implementation of an integrated collateral management system automatically reduces operational risk by linking technology and business activities. It allows for the consolidation of collateral agreement information and the management of collateral positions more efficiently.

Within the new world order, the old cookie-cutter approach doesn’t work

Until recently, risk was managed on a departmental basis. With the changing market dynamics, it’s become compulsory that risk be managed across the enterprise. Market participants must make more of an effort to correlate their risks across the board by moving toward all-encompassing collateral management programs to handle repos, futures, securities lending, and OTC transactions. An effective collateral management program provides the ability for daily reconciliation. Instead of reactionary dispute resolution -- which until recently has been the norm – proactive reconciliation reduces margin call discrepancies and prevents disputes from happening in the first place.

Cross-product margining enables firms to take a one-stop shopping approach from their counterparts or prime brokers. Thus, the market (especially tier 1) are learning to tear down the silos within collateral management and offer one inclusive and consolidated collateral view to their counterparts. For example, if with one master agreement there is a loss, but with another there is a larger gain, margin requirements and transactions are kept to a minimum and counterparties don’t employ as much capital. By netting multiple margin calls across products into a single call, hedge funds are achieving greater capital efficiency and broker/dealers are delivering improved client service. As trading volumes continue to grow, achieving greater economies of scale through consolidation becomes more compelling.

In summary, recent experiences confirm that there is no substitute for the establishment of a strong enterprise-wide credit risk management culture. The demand to hedge credit exposure, yet take advantage of new and lucrative products, will require enabling technology such as automating collateral management. As a result, banks, hedge funds, administrators, custodians and corporations will be able to participate in the market while managing more complex products at faster speeds. Priorities should include reducing operational risk through clearly articulated collateral agreements, and employing systems that automate the monitoring of the performance of those agreements. Tools and procedures that improve control and reduce operational risk are essential for adding a layer of protection between financial markets and the next crisis.

Helen Bramley
Director Product Management
Colline® Collateral Management
Helen.bramley@lombardrisk.com
T: +44 (0) 20 7834 5000