New regulations have opened up a Pandora’s box of opportunities and challenges. What effects are we seeing on the market?
There has been a lot of discussion around regulations, especially around the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) Uncleared Margin Rules (UMR) and mandatory clearing, which have vastly increased the daily number of margin calls. The industry has gone from a world where firms potentially had a single daily margin call for their variation margin (VM), to having as many as four margin calls, in the shape of the legacy VM call, a regulatory VM call, plus the two-way regulatory initial margin (IM) calls.
We have also seen the new regulations change the composition and financial accounting of the collateral that is being moved. Historically, VM was predominantly moved in cash and that remains the case today for both legacy and regulatory VM. Regulatory IM, however, mainly involves the movement of security collateral. We have seen this through the first four phases of UMR up to September 2019, with the movement almost entirely within the triparty agents. The fact that regulations have mandated the quality of the collateral and obliged firms to segregate the collateral so they cannot re-use it, has led to a considerable amount of high-quality collateral, and therefore liquidity, being removed from the market.
To give an idea of this impact on liquidity, the International Swaps and Derivatives Association (ISDA) margin survey conducted at the end of 2018 found that the 20 largest market participants (phase-one firms) collected and posted approximately $167 billion of regulatory IM for their non-cleared derivatives transactions at year-end 2018. Of the posted collateral, 88.4 percent was in government securities, which if consistent across the collected collateral, means that approaching $150 billion of high-quality liquid assets (HQLA) have been removed from the liquidity supply. This will obviously increase as the future phases of UMR impact more financial institutions.
What impact are these challenges having on collateral operations?
There is no way that the mainly manual collateral management processes could cope with a potential fourfold increase in margin call volumes. Nor could they handle the increased complexity of managing disputes in IM calculations, which are far more complex than the simple trade-level net present value required for VM, or with moving securities as collateral. This has created both an opportunity and a necessity for systemic solutions to solve some of these problems. For example, as firms are now moving securities for regulatory IM, they will almost certainly need interfaces to multiple triparty agents, who provide the regulatory segregation models. This is why Calypso has made a significant investment in connectivity to triparty agents and market infrastructure providers. In addition, there is the increased funding cost and the requirement to source the collateral, which means that collateral management needs to be integral to the front office processes. Front offices are now obliged to identify the true cost of the trading, funding costs included. But they must also look at where they should perform the trades; and whether/where they are going to clear the transactions, based on the information that is held within their collateral management systems.
The front office really must understand their costs and, from an opportunity point of view, have visibility and transparency. This is where systems like Calypso come in, offering an integrated front-to-back solution rather than a stand-alone collateral management system. Information that is normally stored in back-office systems needs to be accessible within collateral and inventory management systems.
How is the new regulation driving banks to integration and consolidation?
Regulation is providing opportunities because the collateral impact on both cleared and over-the-counter (OTC) derivatives trading means front-office users need to have much more information from the collateral agreement integrated into their decision-making tools to allow them to make execution decisions at the time of trading. For example, they need to know the details of the threshold in the CSA, what portion of that threshold has been utilised, and what is available. They must also understand the terms of the collateral schedule is having that information is essential for traders to make the correct decisions.
Then, given the increase in the amount of collateral that is required to cover regulatory IM, and also the quality constraints, banks need to have a more holistic view of the full inventory of their assets because they are using those assets to cover liquidity for the general financing of their repo and securities lending, as well as for collateral management exposures.
And let’s not forget that while we have been talking about the drivers from UMR, we have another set of regulations coming along: the Securities Financing Transactions Regulation (SFTR), the first phase of which comes into place from April 2020. SFTR will oblige banks and investment firms to report all the details of their securities financing transactions and lifecycle events, as well as the assets being used to collateralise them. This is where the combination of collateral, financing and liquidity comes into play. With the additional SFTR requirement to report collateral re-use, banks absolutely need a holistic view of financing and collateral management. And for collateral re-use, they need to know their trading positions in those securities. So, it is even more important to be able to access all that information together, rather than having to aggregate from disjointed systems.
What real-life use-cases are you seeing for new technologies to automate manual processes and cut down on inefficiencies today?
The whole collateral management process is relatively new. The first ISDA credit support annex was negotiated in 1994, so we have only been ‘doing’ collateral management for 25 years, and there was very little investment in the market infrastructure to support the process before the recent regulations. Collateral management was something new – and belonged in the depths of the back office. We know anecdotally, for example, that Excel and Email remain two of the most frequently used collateral management tools. The financial crisis and the UMR requirements that followed have changed this, particularly with the growth of the utilities. In the course of the first four phases of UMR up until September 2019, which brought into scope just over 200 of the world’s largest banks and investment firms, we saw utilities emerging as market standards for messaging and reconciliation of the standard initial margin model (SIMM) calculations. This has increased automation significantly. As these utilities have become the standard, of course you need to connect to them. But this is only part of the story. Providers like Calypso can add real value in the automation and the validation of these processes.
For example, Calypso has automated not only the sending and receiving of the messages but also the processing required upon receipt. We can add rules for checking eligibility when collateral is pledged, and for checking the settlement date is correct. We can automate the process to automatically accept the call, dispute the call, accept or reject the collateral.
How far can automation really go in the collateral space? Will there always be a need for people?
In the past, a collateral team would be moving mainly cash, with a small number of calls and using largely manual processes. Multiply the volume of work they were doing fourfold potentially, and there is no way that financial institutions are going to quadruple their collateral team. Having said that, automation won’t replace people altogether.
We will always need people to manage exceptions in the collateral management process. We talked earlier about the complexity of the SIMM calculation, a much more complex value-at-risk-based calculation than the simpler VM, and in the event of disputes, far more difficult to identify the cause of dispute. I think the value is in automating the processing and communication so that the collateral team can concentrate on managing exceptions and on identifying where the real risks exist in the process, rather than sending and answering emails, and checking the pledge that has been sent is correct. The systems can do all that.
How important is the cloud for collateral management?
We are seeing a move towards cloud technology because of the cost benefits of not having to host software. But, at Calypso, we don’t believe that cloud is the answer to every question; cloud doesn’t work for some firms. That is why we have a ‘deployment agnostic’ approach, so firms can deploy on-premise, or we can host the software, or it can be deployed purely in the cloud. Cloud is here to stay. We have seen that from the increase in investment from companies like AWS, who are also breaking down some of the regulatory barriers related to the geography of data hosting. We are seeing more of an interest in the cloud to reduce the cost of hardware. But from a Calypso point of view, we believe that on-premise deployment is still something that many of our clients want—so we prefer to offer a mix of deployment options.
What is Calypso doing to innovate and how is it prioritising investment in new technologies?
As I said, we are making sure that our technology can be deployed in the cloud or can be hosted. We are making a major investment in microservices. We are creating an ecosystem of microservices that will be available to our clients, who can decide which of those services they want to use, and these will be deployed independently as part of their infrastructure. A microservices-based approach will reduce the need for clients to have major upgrades of their Calypso implementation; they will just need to upgrade the appropriate microservices. It is a popular concept as it offers firms entry level access to a system like Calypso. Naturally, these microservices can be deployed in the cloud.
A microservices-based approach also enables firms to consolidate their infrastructure. The new regulations have driven a need for greater visibility into banking systems–and for those different systems to connect. Microservices allow financial institutions to consolidate in an incremental way to provide the essential visibility and information.
What are your predictions of how collateral management will look in five to 10 years?
This is difficult to answer. Not least because of the rate of change that we have seen in the past three to five years and the huge change in collateral processing, technology and infrastructure in the past couple.
From a processing point of view, we will continue to see a move towards automation, combined with exception-based management. This will be driven partly by the need to reduce costs, and as a result of the increased number of calls that firms must make and the additional controls that they will need.
We will also see an increase in triparty services to further automate the collateral allocation process and could potentially see additional triparty agents emerging to add competition and to unlock additional sources of liquidity. I also expect a move towards interoperability between those providers.
Finally, I anticipate greater system consolidation as firms need to have more of the information held traditionally in the back-office and collateral systems available to users at the time of making the trading decision. So we will see consolidation from a systems infrastructure perspective, to enable banks to achieve that overall view.
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Rich Hochreutiner
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