In the second of a series of articles on collateral management strategy, Bob Currie examines steps to address collateral fragmentation, potential benefits from tokenisation and the essential need to be working with good data
In the first of this series of articles on collateral, published in SFT 321, we discussed how regulatory drivers, macroeconomic conditions and operational priorities have each played a role in driving firms to upgrade their collateral ecosystems and take an enterprise-level view of their collateral inventory and financing requirements.
Regulatory changes are forcing a new community of firms into the collateral world and requiring established players to minimise balance sheet cost and remove operational drag. With an expanding range of firms required to manage initial margin (IM) and variation margin (VM), as they have fallen into scope of Uncleared Margin Rules (UMR), these firms are looking for automation, better inventory management, as well as innovative new ways of managing these priorities.
Sophie Marnhier-Foy, global head of product marketing at Adenza, indicates that new regulations have highlighted the interdependency between collateral management, clearing and risk, reinforcing the need to eliminate silos. Firms are managing higher volumes of cleared transactions, cross-margined portfolios, and UMR-mandated trades, all resulting in an exponentially growing need for efficient collateral management and advanced processing. “All those changes call for platform modernisation, simplification and consolidation and a need for more granular data,” she says.
Martin Walker, head of product management at Broadridge Securities Finance and Collateral Management highlights the importance of “getting the basics right” as a fundamental step to good collateral management. Good data husbandry is fundamental to this process — working with clean, well-maintained data sets. “The most effective input in building high-quality collateral management solutions is working with good data, well structured data, coming from the right sources,” says Walker. This is a proven technique over many years and applicable across business areas. “The industry needs to keep coming back to these basics.”
Specifically, it is important to onboard client data into a single, consolidated database within the firm’s infrastructure, ensuring that the client has a clear identifier (typically the Legal Entity Identifier, LEI), attaching the relevant standing settlement instructions (SSIs) and ensuring that this golden-record dataset is accessible to relevant systems within the enterprise. Working with accurate securities data, legal entity data, inventory data and master agreement data is essential to minimising risk across the transaction lifecycle.
Collateral fragmentation
As an industry, we have been focusing for many years on how to reduce collateral fragmentation across product silos (securities lending, repo, exchange-traded derivatives, OTC derivatives) and geographical locations. SFT asked industry specialists how advances in technology and process innovation will define the next set of improvements in collateral mobility and enterprise-wide collateral aggregation.
Will Thomey, co-head of business development at Acadia, proposes that much of this fragmentation was the result of years of siloed business practices and, to some extent, jargon or language. As market participants have constantly reorganised their businesses and supporting collateral organisations, most have already concluded that the differences across markets are self-imposed and arbitrary.
Of course, market nuance exists, Thomey notes, but the 80/20 (or more likely the 90+/10-) rule is accurate where a vast majority of the markets operate consistently — especially in terms of collateral management, but this is equally true across post-trade support.
Jurisdictional differences are slightly more complicated, with some stand-out variations from market to market — for example, the inability to net exposures, heavily prescriptive client money rules, unique reporting requirements or strict segregation requirements. “That said, when factoring in the size and depth of jurisdiction combinations, one would easily conclude that consistencies far outweigh inconsistencies,” says Thomey.
Broadridge’s Walker notes that the industry has been exploring how to centralise collateral pools for more than 15 years. In practice, many firms still operate multiple different sub-teams across their exchange-traded (ETDs) and OTC derivatives, repo and securities lending desks, with these sub-teams often operating different collateral systems. He indicates that Broadridge is working to move beyond this scenario to offer a single collateral solution to support a firm’s activities across these trading areas.
In doing so, he suggests that his team did not begin by looking at ‘pain points’, but rather at points of commonality. “While a lot of trading activity for repo and securities lending is done at the individual trade level, particularly for ‘specials’,” he says, “it is still possible to find common ground across product areas.” For example, risk management and margin management for derivatives is commonly handled at portfolio level, while for securities-based lending it is also common to handle some trade types — trading baskets of general collateral for instance — at a pooled level.
No doubt the workflow across these two trade types differs substantially. But in delivering a centralised view of the inventory, in mobilising and allocating the assets that a firm may use to collateralise a portfolio of derivatives contracts or a pool of securities lending trades, Walker believes these scenarios are conceptually similar. A key principle in the solutions design is to take advantage of these commonalities, while still recognising the differences and accommodating these differences into the solution. In practice, there tends to be significant overlap in some areas — for example, in portfolio valuation, processing margin calls, managing substitutions and disputes relating to valuation of trade positions and collateral.
In handling derivatives exposures, Thomey believes that Acadia offers a very real example where its Margin Manager service has standardised the messaging of margin requirements and its IM Exposure Manager solution has been part of a standard global framework supporting the Uncleared Margin Rules (UMR), while also catering for minor, but truly necessary, market or jurisdictional nuances.
In short, technology is not the limitation and as the value proposition continues to unfold to centralise collateral management — across technology, operations, and funding and liquidity — Thomey believes that the self-imposed silos that remain will continue to fade.
Solving for now
For Pirum’s head of corporate development and collateral services Todd Crowther, decade-long challenges are now being solved for today. He tells Securities Finance Times that the firm is delivering solutions to address three foundational challenges: connectivity, centralised data and collaboration.
Elaborating on this point, Crowther explains that, over the past 20 years, Pirum has built a market-wide network which acts as a connectivity hub for participants to interact agnostically with a wider ecosystem. It has developed a centralised data model, including backward integration to industry-driven common domain models (CDMs), which consolidates and normalises data to deliver a standardised, streamlined front-to-back platform supporting product lines that were traditionally managed in industry silos.
Alongside this, its networked services have enabled participants to collaborate across this wider ecosystem, enabling straight-through processing not only as a centralised process across internal business lines but also by extending process automation across industry participants including their counterparts, vendors and market infrastructure.
Pirum released its CollateralConnect collateral optimisation service extension in January 2022 and reports that it now has 125 clients up-and-running on its exposure and collateral management service, including broker-dealers and banks that are optimising collateral on a daily basis.
Eric Badger, BNY Mellon’s global head of sales and relationship management for clearance and collateral management, notes that it has long been evident that the global collateral landscape is somewhat fragmented, making it challenging for market participants to deliver securities easily to locations where they can be posted efficiently as collateral. He indicates that the bank has made big strides in developing solutions to reduce market friction and remains committed to establishing further connectivity across the marketplace, including with CCPs, new markets such as Indonesia and Malaysia, custodians and other key depositories globally.
“Our one-platform strategy and interoperability tools facilitate the efficient movement of collateral to meet client obligations across BNY Mellon’s collateral platform,” he says. “Our collaborations with Pirum and Baton Systems notably will combine our collateral optimisation services with their aggregation, connectivity and data services.”
“The future is now for Pirum clients,” claims Crowther. He explains that the firm’s CollateralConnect service connects those firms to multiple collateral venues and leverages real-time data-driven APIs and algos to provide intelligent, STP-directed allocations. Clients benefit through decreased operational risk and credit risk via efficient exposure and margin management. The service helps them to lower their funding costs, access secure financing and inventory utilisation within their securities businesses, as well as better performance and prudential compliance around, for example, Liquidity Coverage Ratio, Net Stable Funding Ratio and risk-weighted asset considerations.
In October, the company launched a collateral optimisation service with BNY Mellon to support margining, risk management and inventory management for collateral givers. The solution, ECPOConnect, brings together BNY Mellon’s ECPO service, which provides optimisation across more than US$4 trillion in assets annually, and Pirum’s CollateralConnect platform.
A feature of Broadridge’s SFCM collateral management solution, notes Martin Walker, is that it was first developed to support the securities lending and repo trading areas prior to being integrated into a wider collateral management service. It is essential for both repo and securities lending desks to have a centralised, near real-time view of the inventory and how this can be allocated most efficiently for loan or financing purposes. “This was a starting point in building our platform four years ago, enabling us to develop the core inventory management engine that has subsequently become the backbone of our collateral management service,” he says.
Having built a system targeted initially at securities lending and repo trading, Walker indicates that Broadridge’s collateral solution provides a clear and integrated view of a firm’s inventory. In contrast, collateral solutions that have grown from a different starting point — particularly those supporting margin requirements for non-cleared OTC derivatives — have tended to emerge with different strengths, particularly their ability to offer automated end-to-end workflow and to handle some of the wider data requirements fundamental to derivatives collateral management — for example, ensuring alignment with credit support annexes (CSAs) and collateral eligibility schedules.
Over the past 12-24 months, Broadridge has focused on improving the workflow functions embedded in the system and improving its ability to handle master agreement data. With this combination of efficient inventory management, automated workflow, along with a strong understanding of master agreements and collateral eligibility, Walker believes the company has the essential components in place to deliver a comprehensive enterprise-wide collateral management solution.
Collateral mobility
J.P. Morgan’s head of collateral services for EMEA Graham Gooden points to two parallel directions of travel in terms of improving collateral mobility. The first is to improve efficiency of collateral transfer for traditional collateral assets. To provide one example, J.P. Morgan has combined the benefits of its triparty solution, optimising collateral allocation from the client’s longbox, with the ability to support direct delivery of collateral, for example to meet margin requirements at a central counterparty.
This solution, J.P. Morgan’s CCP Margin Exchange, brings together the benefits of traditional triparty collateral management with the preference of some collateral receivers, in this case a CCP, to receive collateral bilaterally, notes Gooden. “This ability to offer direct collateral delivery from the clients’ triparty longbox is new to the market and is not, in our understanding, currently offered by other triparty providers.”
A second development priority is to apply tokenisation to manage transfer of collateral ownership without the need to move the referenced asset between buyers’ and sellers’ accounts at their respective custodians. “In summary, our approach is that we need to move the needle, not move the asset,” says Gooden. “By creating a token that references the underlying asset, transfer of ownership can be managed on DLT without the need to move the underlying security.”
In May 2022, J.P. Morgan settled its first transaction using tokenised money market funds as collateral. To support this collateralised trade, J.P. Morgan released a new application on its Onyx Digital Assets blockchain, enabling trading participants to transfer tokenised money market fund (MMF) shares on blockchain as collateral. Both collateral provider and collateral receiver must be present on this blockchain-based application, which is known as the Tokenised Collateral Network (TCN).
The tokenised collateral application was developed jointly between J.P. Morgan’s Collateral Services team and Onyx. Following this execution of a collateralised trade using tokenised MMF shares, J.P. Morgan aims to expand this model to enable transfers of tokenised equities, fixed income securities and other assets as collateral.
This release follows the development of J.P. Morgan’s intraday repo service on Onyx blockchain that completed its first live transaction between its broker-dealer and banking entities in December 2020.
Acadia’s Thomey, observes that in the absence of natively-issued digital assets, tokenisation is being deployed to improve the legal transfer of traditional assets between two counterparties. However, this requires what he calls the “‘on-ramping” of assets onto a tokenisation service, which will need to leverage existing traditional settlement processes.
“The value proposition is therefore achieved after an asset has been on-ramped and tokenised, delivered from one party to another, and then further re-used (or rehypothecated),” says Thomey. The advantage is that this chain of transfer can happen quickly and it removes the operational friction that may exist with traditional settlement across custodians or banks.”
However, Thomey also points to ongoing limitations with this on-ramping process. These include difficulties in transferring many assets — or a pool of collateral — simultaneously owing to real-world eligibility and valuation differences between counterparties and the lack of a proven mechanism for delivering tokens safely across networks. A potential outcome, as the process evolves, is that this may lead to the creation of a new set of infrastructure silos.
For Thomey, it is unclear if the overall benefits of tokenisation will outweigh new service costs without high rates of adoption. As such, many market participants are split between pursuing tokenisation and incrementally improving existing settlement capabilities, especially until natively digital high-quality assets, and a robust supporting network, are firmly established.
Further, current appetite to adopt existing digital assets (e.g. crypto) is limited owing to basic concerns around price stability, the balance sheet impact (given that these assets do not qualify as high-quality liquid assets for example), and the need to source legal opinions to confirm their legal treatment in different jurisdictions. Ultimately, Thomey believes that the true digital assets value proposition will not be realised until these are fully embedded within every aspect of trading through to settlement.
According to Todd Crowther, Pirum is investing in future technologies such as distributed ledger technology to drive positive changes to market structure. “This is not a token gesture,” he says. “We are actively working with platforms that are bringing tokenisation products to the market to help participants manage their transactions and margin across the full lifecycle — irrespective of their use of physical or tokenised collateral.”
To drive future change, Pirum is enabling participants to build on their existing processes and infrastructure to agree and instruct exposures, identify eligible tokens as well as to deliver and manage tokenised collateral as part of their existing operating model. “This can lower barriers to entry, reduce participants’ initial and ongoing cost of adoption and bring added liquidity needed by the platforms themselves,'' adds Crowther.
Optimisation priorities
In the first part of this article, we noted that collateral optimisation is key in helping clients to mobilise and allocate collateral efficiently — and to realise associated benefits in terms of funding, liquidity and capital efficiency. But optimisation is a portmanteau term that means different things to different categories of user, with optimisation requirements often differing significantly from one collateral holder to another.
Looking across its client base, Acadia’s co-head of business development Stuart Smith notes that there are stark differences between a Tier 1 bank looking to optimise its IM posting through large scale coordinated multilateral optimisation runs all the way to smaller hedge funds that are looking to manage their exposures below threshold for longer. “These different types of requirements use the same underlying mathematical optimisation tools, but with radically different implementations.”
Smith indicates that the derivatives risk and margin automation specialist — which London Stock Exchange Group has agreed to acquire subject to regulatory approval — is working with its clients to bring a number of other new services to market, including pre-trade analytics to help clients project their IM costs and optimisation services which enable them to reduce IM once it has been incurred. Beyond this, Acadia is targeting other known pain points, including development of a new service to help firms through the recalibration period, enabling them to know exactly what new liquidity draws could occur after a recalibration event.
As banks’ business models move from being dominated by credit risk and associated capital to being more focused on liquidity risk, optimisation of collateral posting becomes key, says Smith. Its new optimisation services are designed to enable firms to offset risk between counterparties and reduce their IM requirements. “Acadia has a unique position as a central hub of the market, making it uniquely placed to provide such a service,” he adds.
Optimisation requirements differ substantially from one service user to another, confirms Broadridge’s Walker. Consequently, it is inappropriate to talk about a generic optimisation process that is applicable for all collateral management clients.
Some firms, for example, are building powerful tools to optimise their balance sheets, taking into account liquidity, levels of leverage, balance sheet composition and other relevant factor inputs. This is one specific set of optimisation priorities applicable particularly to banks, to dealer firms, to help them optimise their regulatory capital and use of HQLA.
For other firms, collateral optimisation priorities are substantially different. Instead, they may focus, for example, on identifying the cheapest-to-deliver securities against a specified set of counterparties. For a global firm with derivatives and securities finance trading interests in multiple locations and time zones, Walker indicates it is important that optimisation moves ever closer to real time and that collateral transfers are highly automated to ensure that risk exposures are effectively collateralised.
While this demands high STP rates and high levels of automation, there are instances where it is important to exercise human judgement. If a portfolio manager is about to sell a large block of securities, for example, human input may be needed to reflect the forthcoming changes to inventory in the optimisation model. In turn, if the front office books a trade incorrectly, manual intervention may be necessary across downstream systems, including collateral systems, to rectify erroneous trade details and to minimise any negative impact on collateral allocation.
The optimisation model will also need to recognise the requirement in some jurisdictions to segregate assets posted as collateral — which may impact opportunities for collateral re-use. For example, CFTC rules require a swap dealer or major swap participant to segregate IM posted by a bilateral counterparty in a segregated account with an independent custodian — if this is requested by the counterparty.
For Pirum’s Crowther, optimisation is a lever for transformation and innovation. “By leveraging Pirum’s platform in terms of ‘datafication’ and ‘electronification’, firms are able to realise business transformation and achieve significant benefits of financial innovation with a minimum of delay,” he says. Providing connectivity across traditionally siloed businesses within firms, as well as enabling interoperability to an ever growing set of external participants and collateral locations, means that firms can consolidate, centralise and streamline operations quickly and easily across the enterprise.
Real-time, standardised data can then be applied to create a broader, deeper and more accurate information set which, in turn, can be utilised on more advanced optimisation techniques — such as machine learning and artificial intelligence — to drive enhanced results that were previously unrealisable. “This means that we can help firms not only to source, manage, substitute and pledge eligible collateral assets in the most cost-effective way on a post-trade settlement basis but, more importantly, they can better optimise their trading businesses and generate meaningful alpha through to better pre-trade, trade and post-trade decision making — including improved pricing, execution and book management,” concludes Crowther.
An agile approach
For Adenza’s Marnhier-Foy, transformation invariably requires time and can be best achieved through an agile, milestone-based process. “This begins with a strategic vision and holistic planning to support all use cases. If there is one thing we have learned from the recent evolution of the collateral and clearing functions, it is to be proactively ready for changes. The journey is just starting,” she says.
In a complex and new market environment, combining challenges based on geopolitics, market risk and increasingly sophisticated use cases, Adenza has responded by adapting its solution. This has included steps to promote collateral defragmentation, to manage the increased cost of funding and other requirements. With the new complexity and cost of collateral use cases, the market has demonstrated that collateral is no longer a sequential function. Collateral information is needed as early as possible in the pre-trade stage if firms plan to optimise their precious securities inventory. In this context, an integrated collateral, front and back office and risk platform offers the best path towards profitability and optimisation.
Second, running complex collateral analysis pre-decision demands that a lot of data and computation is processed rapidly and often. This is necessary to deliver results quickly and to avoid an explosion in the cost of infrastructure.
While market requirements can be very demanding, the good news is that there are also many new technologies and mathematical approaches which can be used to provide quick, complete and accurate pre-decision information. For example, Adenza has innovated and leveraged cloud elastic grids, enhanced data grids and new risk algorithms to offer faster and cheaper pre-decision tools, driving the market best practice around what-if simulations and pre-decision analytics.
With respect to cloud hosting, Marnhier-Foy indicates that Calypso CapCloud has been widely adopted by the Adenza user community. This reduces time to market and supports faster software updates. “The objective is to allow clients to focus on their business, while Adenza’s cloud team manages the platform hosting, including upgrades and software rebase,” concludes Marnhier-Foy.
