As capital markets firms experience economic uncertainty, market volatility and trading volume peaks due to the COVID-19 pandemic, the collateral management function – as it did in the financial crisis starting in 2008 – is again coming into focus. While collateral management may not be in the spotlight during most market cycles, its importance is magnified during times of economic contraction and high volatility.
While the development and impacts of the pandemic are still unclear and the situation continues to evolve, three key requirements for the collateral management function have become evident in the past months:
- An efficient and scalable collateral operation
- Increased counterparty credit risk transparency and caution
- The need to soften liquidity impacts
Many firms have addressed these needs so far with a short term, tactical focus to navigate successfully through the current situation. And they did so reasonably well, given the lack of news coverage on any collateral management related issues.
Nonetheless, firms should now also consider looking beyond the short term perspective to further crisis-proof, scale and improve their collateral function with a medium and longer term perspective in mind.
In the medium term, firms need to think about reconfiguring the collateral management function with a focus on counterparty health and liquidity management and start focusing on operational scale.
Steps to accomplish this would include:
1. Confirm credit risk measures are taken and legal agreements nuances are understood.
- Confirm all collateral processes are tightened up and nuanced scenarios are accounted for. Typical examples are confirmation of collateral eligibility/haircuts (the firm’s own and those of the counterparty) or understanding the implications of ratings changes (such as downgrade triggers or impacts on eligible collateral/haircut).
- Review specific exception scenarios with legal, such as bankruptcy clauses, non-standard dispute handling and other cases.
- Implement effective real-time reporting on counterparties including counterparty relationships, legal agreement terms and other requirements.
- Integrate additional counterparty credit insights such as internal ratings and credit default swap spreads from internal risk departments to understand recent developments.
2. Confirm collateral is effectively deployed to further support the firm’s liquidity measures.
- Identify and review trades driving margin and drilling down to assess whether novation and/or porting can reduce these requirements.
- Optimize the collateral itself, both pre- and post-trade.
3. Reassess the collateral management operating model with the objective of incorporating increased operational efficiency. This should also incorporate learnings based on the current virtual operating model.
- Review workflows and procedures to identify additional automation opportunities. Additionally, underlying reasons for resource bottlenecks in peak times should be addressed (e.g. by cross-training resources, etc.)
- Retire processes requiring manual touchpoints (e.g. settlements processing via Fax)
In the longer term, firms should develop further capabilities for the collateral management function via automation and reduced operational risk while further enhancing capabilities.
Key measures to achieve long-term gains include:
- Enhance platform integration. Implement an automated, integrated, real-time solution across collateral types including “meaningful” integration into all areas.
- Enhance the operating model. Design an organizational structure that enables both scale and expertise.
- Facilitate digitized agreement management. Remove a key driver of manual intervention by installing a comprehensive end-to-end solution that allows storing, digitizing and distribution of collateral terms.
- Adopt new utilities. Adoption of new market utilities such as DTCC MTU and AcadiaSoft for Interest Statements is recommended to further increase the ability to scale.
- Standardize legal agreements for unwanted terms/provisions. Remove anomalies and areas of risk identified such as dispute handling, eligibility, bankruptcy clauses and others.
- Improve integration into liquidity management. Providing real-time transparency, but also perform margin reducing measures and effective collateral enhancement.
- Add What-If Capability. Facilitate flexible and real-time capability with meaningful analytics across scenarios and/or sensitivities. Capabilities should be able to cover views for counterparty health and managing liquidity. These should not only be based on historical data, but also support forward looking stress testing.
- Enhance controls and transparency. This should extend across the collateral function.
Even though the UMR postponement provides some breathing room to firms in the collateral space, the current crisis and path ahead requires specific attention. Firms should try to keep the momentum gained from UMR-related projects while focusing on broader improvements. The collateral function should act as an effective credit risk mitigator, reducing liquidity impacts while running as a scalable, efficient operation.
Firms should therefore take the opportunity, not only to tactically address the short-term effects of the crisis (or of new regulations), but also to future-proof the collateral capability in the long term.
Please reach out to me at firstname.lastname@example.org if you want to discuss this further.
And special thanks to Benedikt Seelhorst for his contributions to this blog.