2016 FIS Webinar, The Economics of Collateral Management. and Making a Profit

The Economics of Collateral and Making a Profit

June 2016

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© 2016 The OTC Space Limited2

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Introduction

Bill Hodgson


Background


} Going back ten years or more, Collateral Management was in many firms seen as an adjunct to their Operations or Credit risk teams. Given the easy profits from trading, little attention was made to the flow of margin assets or their cost, as these were a side-line in the overall profits of a firm.

} The first step change for a CM team was the arrival of SwapClear in 1999, and the take up of clearing by a core group of banks in 2000 with the drive to automate the clearing process. SwapClear requires Initial Margin which was a new idea for OTC products. Most Credit Support Annexes at the time required net mark-to-market (or Variation Margin as most call it now), and no additional amounts (other than some customised CSAs for FX or Prime Brokerage).

} Initial Margin became a new cost to the CM team, and forged a new relationship with the Repo / Treasury desks – as someone had to bear the funding cost of the IM, and it couldn’t be the CM team itself who have no profit to spend. This became the genesis of an evolving relationship between the front office and the CM teams – and also the Risk Management team to understand why the IM at SwapClear is driven higher or lower, and therefore increasing or decreasing costs.

Speakers


Ted Allen has specialised in collateral management for nearly 20 years and is currently Director of Business Development for Apex Collateral at FIS. Apex Collateral is FIS's strategic solution for Enterprise Collateral Management. It provides a unique value proposition to manage, trade and optimise collateral assets on a single platform. The Apex Collateral community of clients spans the buy side and sell side in North America, EMEA and APAC. Apex Collateral delivers a compelling solution to the challenges of collateral market reform and the global regulatory environment.

John has worked in capital markets for 15 years+ (10 at Accenture and 5+ as independent consultant). He has extensive experience in derivatives and collateral management having worked both with the sell-side (clearing members) and buy-side (asset managers) and currently focuses on regulatory driven business change. He has previously worked with HSBC, Barclays, Morgan Stanley andAccenture.

Eric specialises in collateral optimisation/trading, funding, liquidity, OTC clearing and client clearing. He currently works on front office collateral optimisation, repo and tri-party repo, liquidity management and short term funding at Commerzbank, and has previously worked with Capco, Goldman Sachs, and Citi Group.

Main Points


} Is cash still king? 80%+ of margin calls are met with cash but in this low interest rate environment, is this still appropriate?

} What are the platform and infrastructure choices to meet the March 2017 non-cleared OTC collateral regulations?

} How can funds utilise their assets to cover margin calls without reducing their return on investment?

} What you really need from an optimisation approach} What new innovations are happening in collateral

management?

Regulations and Market Initiatives

Ted Allen, John Lund, Eric Bystrom


Regulatory and market initiatives

EMIR / DFA etc• CENTRAL CLEARING

• TRADE REPORTING

• MANDATORY RECONCILIATIONS

BCBS IOSCO• FINAL PILLAR OF OTC

MARKETS REFORM

• GLOBAL STANDARDS FOR MARGINING OF NON-CLEARED OTC DERIVATIVES

• PROJECT BLAZER

BASEL III• EXPOSURE

CALCULATIONS AND DISPUTES

• LIQUIDITY RATIOS AND RISK MANAGEMENT

AND OTHERS….• SFTR

• ASSET ENCUMBRANCE

• UCITS, 1940 ACT

• ISDA / ICMA / ISLA BEST PRACTICES

• ….

Challenges• Operational complexity• Regulatory compliance• Increased volumes• Market infrastructure changes

• Increased cost of collateral• Optimisation and Transfer Pricing• Liquidity impacts• Higher capital charges

9

Extra collateral required

$800b

Increase in margin calls

5x

Increase in substitutions

10x

Impact of non-cleared margin rules

JXL Consulting Ltd

Bilateral book fragmentation: derivatives fission

28/06/2016 10

1

2

3

4

51. LegacyBilateral

2. NewBilateral

3. Cleared(Mandated)

4. Cleared(Elective)

5. NewProductse.g.Listedhybrids

Market changes will significantly change the composition of a typical derivatives portfolio over the next few years | a theoretical evolution of categories

Un-cleared Bilateral Margin Rules

11

•Possible Delay to the Implementation of the Rules– EU rules still not final, being reviewed as we speak– “Our objective is to deliver the standard before the end of the year [2016] and

for firms covered by the first wave of the rules to be required to comply before the middle of next year [2017],” said a Commission spokesperson.– Bloomberg: http://bit.ly/BBGUMRDelay– IFR: http://bit.ly/ifrumrdelay

•European Commission may delay implementation for six months – From September 2016 to March 2017 for IM & VM for tier 1 firms– From March 2017 to September 2017 for all firms subject to VM

•No change to US rules timing – leading to a US disadvantage?•Brexit effect?

Poll 1

Familiarity with the Uncleared Margin Rules


13

How familiar are you with the upcoming BCBS IOSCO regulations for margining of

non-cleared OTC derivatives:

1. Deeply and intimately familiar2. Pretty familiar3. A bit worried I should know more4. I don’t understand the question

Poll Results

How well do the audience know the rules?


Preparations at Commerzbank

Eric Bystrom


Poll 2

Challenges in preparing


17

What is your biggest problem in preparing for BCBS IOSCO rules for margining of non-

cleared OTC derivatives:

1. Negotiation of new regulatory CSAs2. Preparing operations processes 3. Technology and infrastructure4. Managing the cost of collateral5. Something else

Poll Results

Which areas are causing problems?


Trends

John Lund


JXL Consulting Ltd

Collateral Trends

28/06/2016 20

Cash Drivers

• Dealer preference for cash only CSAs

• Cleared VM required in cash

• Cash operationally easier

• Current investment environment favours cash

Non cash Drivers

• Fully invested funds prefer non cash

• Some CMs favour non cash for cleared IM

• Increasing cleared IM materiality

• Extension of CCP eligible asset types

• Cash negative rates favour non cash

There is likely to be a gradual shift in favour of non cash

The Economics of Collateral

Eric Bystrom, John & Ted


Managing the Cost of Collateral

•Funding•Returns•Opportunity Cost•xVA & Pricing•Cheapest to deliver Bonds versus Operational capabilities

JXL Consulting Ltd

How can funds utilise assets?

28/06/2016 23

• One size does not fit all in the fund universe.

• Whilst some funds can easily post additional collateral from existing inventory, others (esp pension funds) will struggle to avoid impacting fund returns.

• Any mitigation strategy should be twofold:-Razor focus on reducing “demand” [root cause]-Deploy multiple strategies to make best use of available asset sources

• Asset source optimisation could include:-Change in use of derivatives-Collateral transformation by CMs-Collateral transformation by CCPs-Securities lending-Peer to peer repo-Use of alternative products (e.g. swap futures)

Centralized profit center to unlock the potential of collateral management – Sell Side View?

24

Market trend

Central collateral/liquidity management and trading unitCollateral management(Cross product collateralization)

Liquidity management(Repo / reverse repo)

Enterprise collateral inventoryCross-asset, real-time

Securities lending / collateral trading

Collateral optimisation / collateral transfer pricing

Central view of inventory

Operational efficiency

Enable collateral trading and improve ratio management

Poll 3

Centralised Collateral Management


26

Has your firm established a program to centralise collateral management?

1. Yes, it has been centralised2. Yes, it is an ongoing initiative3. No – but it’s in our plans4. No – we will never do this5. Something else

Poll 3 Discussion

What appetite is there for centralisation?


Future building blocks

John Lund


JXL Consulting Ltd

Infrastructure Building Blocks

28/06/2016 29

A 5 year strategy is essential to deliver the right infrastructure at the right time

2016 2017 2018 2019

IMSim

Cat2IRSClearing

Cat2CDSClearing,

PRIIPs

UnclearedVM

PensionExemption,

MiFID2

UnclearedIM

Pre-TradePost Trade CCP

CollateralMgt

Capacity

Limit Monitoring

VenueSelection

Cost of Collateral

CollateralTransform

Fee Simulations

Feeoversight

Tierassessment

Clearing Eligibility

TreasuryMgt

Intra-day margining

CrossMargining

Concentr.Limits

UnclearedIM

DirectClearing

FundAccounting

Poll 4

Collateral Optimisation


31

What is the state of collateral optimisation at your firm?

1. No need for optimisation2. We are studying the business case3. We are investing in a program4. We have an established collateral optimisation process5. Something else

Poll Discussion

How optimised are attendees?


The Collateral Value Chain

John, Ted & Eric


JXL Consulting Ltd28/06/2016 34

Post tradeCollateral

Optimisation

Pre-tradeCollateral

Determination

•Cross margining

•Cleared IM optimisation

•Bilateral IM

•Accurate cash inventory

•Accurate non cash inventory

•Availability of unsecured financing

•Cost of collateral methodology

•Algorithm to attribute cost over multiple fund managers in one margining pot

•Daily review of collateral

•Substitution over events

•Accurate cost attribution

Optimisation Value Chain

CaptureConstraints

EvaluateSupply

MinimiseDemand

•Haircuts and eligibility

•Concentration restrictions

•Investment restrictions

•Holding costs (e.g. LDR)

Collateral Transformation

“Optimisation” is in reality a number of distinct components

Global InventoryAvailability ladder of positions

Requirements

• cOTC / ETD• Bilateral• Funding• … Requirement 1 Requirement 2 Requirement N

Constraints

• Substitution & Concentration limits• Eligibility & haircuts• Corporate actions• Settlement cut-offs• …

Eligibility 1 Eligibility 2 Eligibility N

Position1 Position 2 Position n

Complexity: How to achieve a holistic allocation that meets all constraints and minimises cost Scale: automate the allocation process – automatic collateral trade creation

Holistic Numerical OptimizationOptimal Allocations:- Minimize costs

- Maximize liquidity

Holistic Post-Trade Collateral Optimization

One last thing

What / how / when is the Asset Shortfall?


Final Question


} What is the “assets shortfall?”} Why might this happen?} When might this happen?} What are the consequences?} Is there any evidence for this?} Does the audience have any views?} Let us know using the Questions panel

Next steps

What should you be doing?


Next Steps


} What should your firm be doing?} Review the current economic effect of your

collateral management activities} Review your operational and technical platforms} Look cross-business (OTC, Repo, Exchanges,

Stock Loan)} Establish an Owner / Sponsor for your Strategy

(if you don’t already have one)

Contact Details


} Ted Allen} Email: [email protected]} Phone: +44 20 8081 3065

Thank you

We will publish this webinar in video, audio and transcript format soon


2016 FIS Webinar, The Economics of Collateral Management. and Making a Profit

Economy & Finance

Transcript of 2016 FIS Webinar, The Economics of Collateral Management. and Making a Profit