Thomas Schiebe, Senior Associate, Business Consulting Neil Wright, Industry Advisor to Sapient Global Markets

Bringing EfficiEncy to collatEral ManagEMEnt Trends, Challenges and Opportunities for Success

FINANCE 1

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2Collateral Survey: White paper

Many market participants have cobbled together fragmented systems, manual processes and siloed approaches for collateral management in order to ensure compliance with various regulatory requirements. Unfortunately, such efforts have made managing and processing collateral a very inefficient and costly component of their businesses. In fact, less than half (45 percent) of participants in a recent Sapient Global Markets survey felt strongly that their institutions have efficient processes for collateral management, particularly in the area of communication and dispute management.1

While regulations continue to drive firms’ investments in new technology and infrastructure, there are also a number of trends influencing the desire to increase efficiency and reduce costs.

ShortfallsAt the same time that demand for collateral has increased, circulation of existing collateral has decreased. According to economists at the International Monetary Fund, declining confidence in issuers and counterparties has reduced the circulation rate of collateral between counterparties from three times its original value in 2007 to just 2.4 times today.2 With issuance of highly rated securitized debt also shrinking, predictions of a worldwide collateral shortfall are possible.

This puts greater pressure on firms to identify eligible collateral, locate it and then match it with the collateral demands they face. If they lack the collateral eligible to meet one of those demands, they have to work out

how to obtain it. Mismanaging collateral can damage performance and reputations, as well as increase costs. Technology and efficient processes play a critical part in steering clear of shortfalls.

Cross Asset NettingNetting on counterparty exposures decreases the amount of collateral a firm must maintain to cover credit risk and protect the balance sheet. Being able to perform pre-trade scenario analysis of counterparty usage and execution can offer significant cost savings to firms. Unfortunately, tools to perform cross asset netting are still in development as technical standards have not been finalized by regulators. Once available, firms will be able to more easily estimate exposure and the impact of a trade and make cost-effective decisions as to which counterparties to trade and clear through.

Optimization of CollateralThe change in current market conditions has put both buy- and sell-side firms under pressure to cut the cost of collateralizing transactions by managing collateral more efficiently. The “optimization” of collateral seeks to make the best use of available assets —a process of allocating collateral based on cheapest-to-deliver in terms of both cost and liquidity. To achieve optimization, firms must have sufficient levels of automation and straight-through processing, as well as technology in place to help identify eligible collateral, prioritize its use and deliver the lowest cost, mutually acceptable form of collateral across an entire firm.

Today, five years into the era of re-regulation, the financial services industry bares the heavy weight of a regulatory framework that is complex, somewhat contradictory and, in some instances, incomplete. New legislation around the globe, including Dodd-Frank, EMIR and Basel III, has created a tangled web of rules designed to increase market stability and resiliency, enhance transparency and accountability and reduce counterparty, operational and liquidity risk. The fallout of regulatory reform for most banks and capital market participants has transformed collateral management into a complex, costly exercise involving higher volumes of collateral, increased margin calls and interaction with more counterparties.

This paper looks at trends in collateral management including cross asset netting, optimization, transformation and shortfalls and discusses areas of internal collateral management where firms must bring efficiency in order to remain competitive and protect revenues.

WhAt iS DriviNg the ChANge iN COllAterAl MANAgeMeNt?

3Sapient Corporation 2014

transformationNew regulations now require derivatives market participants to post collateral with counterparties for both cleared and uncleared transactions. This makes it imperative for firms to have systems in place to know exactly what eligible collateral they have available to meet a collateral call—a requirement that could be problematic for some firms. The Sapient Global Markets’ survey revealed that only half (51 percent) of market participants have a complete view of their entire inventory of eligible assets to be posted as collateral across business units.3

If a firm does not have sufficient, available assets, it can either borrow from a firm through a straight-forward lending agreement, or for a fee, have its lower-grade assets (with significant haircuts applied) transformed into eligible assets. Such transformation services create a new revenue stream for those who can source high-quality collateral and deliver it to clients who need it. Given the revenue potential, over half (66 percent) of custodians surveyed intend to offer or already have a partial transformation service.4

Roadblocks to ImplementIng new collateRal FunctIonscollateRal FunctIon

data & system needs cuRRent Issues

Managing Shortfalls • Automate the identification of collateral and liquidity surpluses and shortfalls

• Manual, back-office process• No collateral forecasts available

Cross-Asset Netting • Custom rules engine for selling and posting assets• What if (pre-trade) scenario analysis for

counterparty usage and execution

• Technical standards for bilateral margining have not yet been finalized by regulators

• Lack of integration across products• Full, cross product netting technology

is unavailable

Optimization • Allocate collateral based on price, risk, liquidity, financing costs, etc.

• Access to consistent, complete and accurate data• Adopt optimization algorithms (covering liquidity,

capital and regulatory implications)• Have complete view of assets across the enterprise• Pool collateral to meet various exposures• Calculate margin and risk across all available

collateral inventory pools• Map counterparties’ collateral eligibility,

concentration and haircut criteria• Improved automation and straight-through

processing

• Difficult to integrate siloed approach and no view of overall collateral inventory

transformation • Have complete view of assets across the enterprise• Real-time view of assets• Automated substitution/eligibility rules

• Manual, back-office process• Impact of regulations still unknown• Difficult to integrate across products• Re-hypothecation rules are still unknown

4Collateral Survey: White paper

As the costs of central clearing, collateral reporting and margining continue to rise, firms will need to bring efficiency to several areas of their collateral management process in order to remain competitive and protect revenues. Not surprisingly, there is an evolution underway which is bringing some functions of collateral management from the back office to the front office. One quarter of Sapient Global Markets’ survey participants indicated they have plans to move collateral management to their front or middle office. Six key areas that need improvements are:

inventory ManagementFirms must have the ability to manage their collateral inventory, in real-time, to meet regulatory requirements. There are also financial benefits for organizations that can make the most optimal use and re-use, where allowed, of their existing collateral inventory.

risk ManagementWith the value of assets changing quickly, firms need real-time access to the level of collateral required, and the ability to track valuations in real-time. It is no longer sufficient for organizations to do this on a weekly or monthly basis. Improved access to collateral information and the use of sophisticated algorithms and rules engines help firms better understand what collateral is eligible, perform “what-if” scenarios, apply complex collateral eligibility criteria, and manage concentration and haircut rules to mitigate risk.

Data ManagementCollateral management relies on thorough data management, including counterparty data, legal agreements, collateral inventory, pricing data, credit ratings, client information and transactional data. Currently, much of a firm’s data resides in various systems and databases. An optimum collateral management approach relies on aggregated data. Additionally, having access to real-time data that is consistent, complete and accurate enables firms to more effectively calculate exposure, manage margins and optimize use of eligible collateral. Improving data quality also gives firms better capability to meet regulatory requirements, enforce compliance and communicate to external stakeholders.

reporting & AnalysisIn addition to meeting regulatory reporting requirements, such as the European Banking Authority requirements for encumbered ratios, firms need the ability to query and report on a wide range of data to make sound business decisions. Firms have much to gain from integrating data from multiple systems and automating their reporting and analysis processes.

Dispute ManagementCost efficiency is one of the main drivers of change in collateral management. Improvements in dispute management and collateral settlement can increase straight through processing (STP), promote efficiency, and realize quick wins. These tasks are often performed manually and therefore require increased headcount. Increased STP rates through automation is a necessity for firms to stay competitive, especially as the volume of margin calls, transferred collateral, reconciliations and disputes are expected to increase significantly.

Communication StandardsAnother critical factor for the successful management of complex collateral processes is the use of a standard messaging format for communicating trade and collateral activities. A good example is the ISDA supported Clearing Connectivity Standard (CCS), developed by Sapient, which has rapidly become the new industry standard for margin statements for cleared derivatives. CCS was developed through collaborative conversations with clearing brokers, service providers and custodians. The standard outlines all of the message elements that should be universally present in margin statements, such as balances, requirements and product cash flows. Adopting a standard messaging format is particularly critical given the growth of market players and clearinghouses globally, helping to reduce both risk and operational burden for all firms involved. Additionally, client portals, which enable firms to show data to clients in real time, are gaining popularity within the industry. These portals are being used to improve client reporting, margin calls, reconciliations, valuations and portfolio analytics.

AChieviNg effiCieNCy: Key fOCuS AreAS

5Sapient Corporation 2014

Bringing efficiency to collateral management will require firms to change their current operating models, architecture and legacy collateral management solutions, which range from simple spreadsheets to more complex systems. Depending on the availability of technology funding and internal expertise, a firm may elect to:

Option 1: Manage in-house with existing SystemsFor firms with their own proprietary collateral management systems, updating those systems may make the most sense, given the level of custom functionality included and compatibility with other internal systems. However, collateral management success will hinge on a firm’s ability to remove siloed approaches and transform their systems into a full-blown collateral management platform. A platform that consolidates the collateral management function across all asset types and provides an entity-wide overview of all available and eligible collateral.

Option 2: Manage in-house with vendor SolutionsA vendor software solution can be an ideal option for firms that do not have—or do not wish to spend—the resources to build and maintain in-house systems or want to add features and functionality to their collateral management that go beyond the capabilities of their existing, proprietary systems. Vendor systems are continuous updated to adhere to the latest regulatory requirements and often include usability features, enhancements and new algorithms requested by customers.

Option 3: Outsource Collateral Management functionsDepending on a firm’s business model and structure, outsourcing can be an effective option to save on operating and maintenance costs. Outsourcing allows a firm to leverage a third party’s targeted expertise and economies of scale for collateral management functions, such as reconciliation, reporting, liquidity management and dispute management.

Choosing to maintain your existing systems, invest in a third-party collateral management system, or outsource specific collateral management functions requires careful thought and a solid strategic plan. Firms often struggle with resolving short-term tactical moves with long-term strategic goals, or have difficulty building the capabilities needed to execute their strategies. Engaging an outside expert with deep collateral management experience, such as Sapient Global Markets, to partner with you to define, design and execute the best collateral management model for your firm ensures:• Best practices and industry benchmarks are

used to design an optimum operating model for collateral management.

• Current state architecture, systems, processes and data sources are accurately inventoried and assessed, and used to support a better collateral management system design.

• Business requirements are gathered from all stakeholders and prioritized and weighed based on the agreed strategy and operating model.

• An objective evaluation of tools and vendors is performed based on the business requirements and optimum operating model.

• Optimization techniques to improve areas such as dispute management, communications and data management are developed.

• System and process implementations are fully managed and tested.

the COllAterAl MANAgeMeNt SOlutiON

6Collateral Survey: White paper

The capital markets sector has already undergone major changes in the past few years—and more changes are still to come that will dramatically increase the cost of collateral. Firms must take action to remain competitive and protect revenues.

Market participants are currently exploring new revenue streams through transformation services, efficiencies with cross asset netting, bringing improvements to processes such as dispute management and communication and reducing costs by implementing collateral optimization strategies. Successful execution requires solid planning, advanced technology and improved processes.

Partnering with a provider such as Sapient Global Markets provides access to deep collateral management and capital and commodity market expertise. Sapient Global Markets can assist firms with business consulting, technology development and managed services to ensure your firm achieves collateral management success.

Next StepS

About Sapient Global MarketsSapient Global Markets, a division of Sapient® (NASDAQ: SAPE), is a leading provider of services to today’s evolving financial and commodity markets. We provide a full range of capabilities to help our clients grow and enhance their businesses, create robust and transparent infrastructure, manage operating costs, and foster innovation throughout their organizations. We offer services across Advisory, Analytics, Technology, and Process, as well as unique methodologies in program management, technology development, and process outsourcing. Sapient Global Markets operates in key financial and commodity centers worldwide, including Boston, Chicago, Houston, New York, Washington, D.C., Calgary, Toronto, London, Düsseldorf, Frankfurt, Geneva, Munich, Milan, Zurich, and Singapore, as well as in large technology development and operations outsourcing centers in Bangalore, Delhi, and Noida, India.

For more information, visit sapientglobalmarkets.com.

© 2014 Sapient Corporation. Trademark Information: Sapient and the Sapient logo are trademarks or registered trademarks of Sapient Corporation or its subsidiaries in the U.S. and other countries. All other trade names are trademarks or registered trademarks of their respective holders.

Sapient is not regulated by any legal, compliance or financial regulatory authority or body. You remain solely responsible for obtaining independent legal, compliance and financial advice in respect of the Services.

7Sapient Corporation 2014

Neil Wright Neil Wright is an industry advisor to Sapient Global Markets with a particular emphasis on derivatives and collateral. A bank operations executive with 25 years of experience in capital markets operations and audit and control, Mr. Wright began his career at Chase Manhattan Bank as an internal auditor where he managed Chase’s Internal Control Group for all operations in Europe, and then became the global head of Derivative Operations. He later joined Citigroup and was the global head of Commodity Operations while also running the Derivative Collateral Management Group. Prior to his current role, Mr. Wright was a senior vice president at State Street Corporation as the head of the Derivatives and Collateral Product and Strategy Group. Mr. Wright has been active in all industry groups relating to derivative operations, including serving as chairman of ISDA’s North American Operations Committee, Board Member of FpML.org., founding member of the SWIFT Derivative User Committee, co-chair of the AMF Derivatives Operations Committee and the ISDA Steering Committee for the Clearing Connectivity Standard.

thomas Schiebe Thomas Schiebe is a business consultant at Sapient Global Markets with a particular focus on trading, treasury, clearing and collateral management. Prior to joining Sapient Global Markets, Mr. Schiebe worked in the treasury department of a medium-sized bank in Germany. An integral member of the clearing and collateral business develop team, Mr. Schiebe has strong expertise in the regulatory environment covering DFA and EMIR requirements, as well as interest rate derivatives, FX products and static data management and regulatory reporting.

AuthOrS

References:1. Sapient Global Markets, “2014 Collateral Survey Results,” April 2014.

2. Hobson, Dominic, “Collateral Makes the World Go Around...,” Financial News, 3 September 2012, http://www.efinancialnews.com/story/2012-09-03/collateral-makes-the-world-go-around 30 May 2014.

3. Ibid.

4. Ibid.

5. Sapient Global Markets, “2014 Collateral Survey Results,” April 2014.

for more information, please contact:

thomas Schiebe – EU

tschiebe@sapient.comNeil Wright – North America

nwright@sapient.comgordon McDermid – UK

gmcdermid@sapient.com

8Collateral Survey: report

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