Winning the fragmentation battle
14 July 2017
Businesses can strategically address their collateral and liquidity management operations and regulatory needs by adopting a more holistic integration approach, says Bimal Kadikar of Transcend Street Solutions
Image: Shutterstock
Financial institutions today are increasingly evaluating how best to manage their collateral needs in the face of dual challenges: adapting their business and operational structures to become more efficient and responding to and complying with ongoing demands around changing regulatory requirements. These issues resemble a seemingly impossible, task, like transferring passengers between two moving trains. Firms that approach front-office transformation challenges, decoupled from regulatory and compliance challenges, will miss opportunities to solve larger systemic issues in a strategic and integrated fashion. We strongly believe that technology strategy and architecture can play a critical role as firms meet these challenges.
Businesses can strategically address their collateral and liquidity management operations and regulatory needs by adopting a more holistic integration approach that takes into account their organisational complexity, unique business requirements and compliance mandates. Firms that get this strategy right will establish a competitive advantage and maximise limited budgets by significantly enhancing their front-office capabilities, while also meeting regulatory requirements.
Managing transformations and challenges simultaneously
Regulations are demanding significant changes to securities finance and derivatives businesses, which are primary drivers of collateral flow. An organisation’s overall portfolio mix dictates the cost of doing business, and having an integrated view of the complete liquidity situation is critical and can’t be done in isolation. These regulatory and economic forces are driving firms to integrate their collateral businesses that traditionally operated as silos.
At the same time, new global regulations are mandating that firms implement specific capabilities and requirements that are often quite broad, affecting many aspects of collateral and liquidity management capabilities. Consequently, these requirements are quite onerous to accomplish especially because they need to be implemented at an enterprise level.
What is required for front-office optimisation?
Typically, financial business units were structured and incentivised to take a highly localised approach to addressing the collateral requirements for their specific business lines. This historical constraint was driven by a need for domain expertise and reinforced by budgeting protocols and performance expectations that were more closely aligned with local returns on capital, revenue and income. In the current environment, making decisions within a single function misses the opportunity to achieve broader benefits to drive valuable optimisation across an enterprise. The outlying boxes in Figure 1 overleaf illustrate the standard, localised organisations that exist in most firms today, where individual business units make collateral decisions without consideration of their sister business’ needs.
Figure 1
Firms that move beyond the silo approach and evaluate and prioritise collateral and liquidity requirements in a more integrated fashion across all of their collateral management processes are better positioned to ensure the optimal allocation of capital and costs, realise efficiency gains, and enhanced profitability. Some organisations are doing this by establishing collateral optimisation units that have a mandate to implement technology and organisational changes across multiple businesses on a front-to-back basis. Potential areas that organisations are evaluating include maximising stress liquidity, streamlining operational processing, reducing the balance sheet by retaining high-quality liquid assets (HQLA) and improving the firm’s funding profile by reducing liquidity buffers against bad trades for non-liquidity coverage ratio (LCR)-compliant transactions.
What is required for regulatory compliance?
While many front offices typically focus on creating optimal technology architecture to improve financial return metrics, there are specific regulatory-focused technology enhancements that additionally need to be implemented. In most cases, these regulatory requirements are implemented by compliance and/or operations areas potentially away from the front-office functions. This is a big challenge as these requirements are at the firm level and most firms don’t have a coordinated collateral architecture in the front. In particular, the US Federal Reserve’s recovery and resolution planning (RRP) requirements, qualified financial Contract (QFC) specifications in the US, and the EU Securities Financing Transactions Regulation (SFTR) are just a few examples that have pressing requirements and deadlines in the near future.
These regulations are creating significant demands on large institutions’ business and technology architecture:
• Track and report on firm and counterparty collateral by jurisdiction (RRP, SR 14-1)
• Track sources and uses of collateral at a security level across legal entities (RRP, 2017 guidance)
• Conduct scenario planning to simulate market stresses, such as a rating downgrade or other environmental changes, that estimate impact on collateral and liquidity position in stress scenarios on a periodic basis (RRP, SR 14-1 and 2017 guidance)
• Deliver daily information on their collateral and liquidity positions—specific QFC reports will cover position-level, counterparty-level exposures, legal agreements and detailed collateral information QFC specifications)
• Report on all securities finance transactions (SFTR)
To fully meet these compliance deadlines within the next 12 to 24 months, most firms do not have the luxury of adopting a strategic approach to reengineer their business and technology architecture and have been forced to take tactical steps to ensure compliance. However, it is likely that achieving compliance in a short timeframe will create huge business and operational overhead costs, as one-off solutions may not be tightly integrated and may require additional manual work and reconciliations over time. The ongoing need for changes to front-office business processes will have an impact on compliance solutions, potentially causing firms to significantly increase the operational overhead of supporting these businesses. This can lead to costs for collateral businesses significantly increasing, despite working hard to drive cost and capital efficiencies.
A better approach—holistic architecture
Firms that choose to tackle these operational and regulatory challenges head-on by investing to create and establish an integrated collateral architecture across business lines will have a significant competitive advantage. In a dynamic marketplace where business needs and regulatory requirements are constantly changing, a component-based architecture can be an effective approach. This allows seemingly complex processes to be managed through careful consideration of the distinct business and technology architecture elements of each stakeholder to achieve the appropriate balance for their strategy in an effective manner.
Figure 2
Key components of holistic collateral architecture
Here are some important drivers to consider in your planning:
• Real-time inventory management capabilities across business lines that can be leveraged by both the front and back office (this is a critical component of the strategic architecture, with the key requirement of knowing firm, counterparty and client collateral by jurisdiction)
• QFC trade repository that is integrated across all securities finance transactions as well as derivatives trades that can be linked with positions, margin calls and collateral postings
• Harmonised collateral schedules/legal agreements repository
• Enabling collateral traceability across legal entities with the ability to produce sources and uses of collateral will ensure regulatory compliance, as well as the ability to implement appropriate transfer pricing rules to drive business incentives in the right places
• Utilising optimisation algorithms with targeted analytics can maximise a variety of different business opportunities and most importantly recommend actions through seamless operational straight-through processing
This transition can be difficult for firms as it will need to cut across business and functional silos and it can have significant people and organisational hurdles along with technology challenges. One key point is that these changes don’t need to happen all at the same time and firms can prioritise the approach in a phased manner in line with their pain points and priorities as long as leadership is behind the vision of the holistic architecture. Many firms have started this journey and those who can make demonstrable progress will have a significant competitive advantage in the new era.
Businesses can strategically address their collateral and liquidity management operations and regulatory needs by adopting a more holistic integration approach that takes into account their organisational complexity, unique business requirements and compliance mandates. Firms that get this strategy right will establish a competitive advantage and maximise limited budgets by significantly enhancing their front-office capabilities, while also meeting regulatory requirements.
Managing transformations and challenges simultaneously
Regulations are demanding significant changes to securities finance and derivatives businesses, which are primary drivers of collateral flow. An organisation’s overall portfolio mix dictates the cost of doing business, and having an integrated view of the complete liquidity situation is critical and can’t be done in isolation. These regulatory and economic forces are driving firms to integrate their collateral businesses that traditionally operated as silos.
At the same time, new global regulations are mandating that firms implement specific capabilities and requirements that are often quite broad, affecting many aspects of collateral and liquidity management capabilities. Consequently, these requirements are quite onerous to accomplish especially because they need to be implemented at an enterprise level.
What is required for front-office optimisation?
Typically, financial business units were structured and incentivised to take a highly localised approach to addressing the collateral requirements for their specific business lines. This historical constraint was driven by a need for domain expertise and reinforced by budgeting protocols and performance expectations that were more closely aligned with local returns on capital, revenue and income. In the current environment, making decisions within a single function misses the opportunity to achieve broader benefits to drive valuable optimisation across an enterprise. The outlying boxes in Figure 1 overleaf illustrate the standard, localised organisations that exist in most firms today, where individual business units make collateral decisions without consideration of their sister business’ needs.
Figure 1
Firms that move beyond the silo approach and evaluate and prioritise collateral and liquidity requirements in a more integrated fashion across all of their collateral management processes are better positioned to ensure the optimal allocation of capital and costs, realise efficiency gains, and enhanced profitability. Some organisations are doing this by establishing collateral optimisation units that have a mandate to implement technology and organisational changes across multiple businesses on a front-to-back basis. Potential areas that organisations are evaluating include maximising stress liquidity, streamlining operational processing, reducing the balance sheet by retaining high-quality liquid assets (HQLA) and improving the firm’s funding profile by reducing liquidity buffers against bad trades for non-liquidity coverage ratio (LCR)-compliant transactions.
What is required for regulatory compliance?
While many front offices typically focus on creating optimal technology architecture to improve financial return metrics, there are specific regulatory-focused technology enhancements that additionally need to be implemented. In most cases, these regulatory requirements are implemented by compliance and/or operations areas potentially away from the front-office functions. This is a big challenge as these requirements are at the firm level and most firms don’t have a coordinated collateral architecture in the front. In particular, the US Federal Reserve’s recovery and resolution planning (RRP) requirements, qualified financial Contract (QFC) specifications in the US, and the EU Securities Financing Transactions Regulation (SFTR) are just a few examples that have pressing requirements and deadlines in the near future.
These regulations are creating significant demands on large institutions’ business and technology architecture:
• Track and report on firm and counterparty collateral by jurisdiction (RRP, SR 14-1)
• Track sources and uses of collateral at a security level across legal entities (RRP, 2017 guidance)
• Conduct scenario planning to simulate market stresses, such as a rating downgrade or other environmental changes, that estimate impact on collateral and liquidity position in stress scenarios on a periodic basis (RRP, SR 14-1 and 2017 guidance)
• Deliver daily information on their collateral and liquidity positions—specific QFC reports will cover position-level, counterparty-level exposures, legal agreements and detailed collateral information QFC specifications)
• Report on all securities finance transactions (SFTR)
To fully meet these compliance deadlines within the next 12 to 24 months, most firms do not have the luxury of adopting a strategic approach to reengineer their business and technology architecture and have been forced to take tactical steps to ensure compliance. However, it is likely that achieving compliance in a short timeframe will create huge business and operational overhead costs, as one-off solutions may not be tightly integrated and may require additional manual work and reconciliations over time. The ongoing need for changes to front-office business processes will have an impact on compliance solutions, potentially causing firms to significantly increase the operational overhead of supporting these businesses. This can lead to costs for collateral businesses significantly increasing, despite working hard to drive cost and capital efficiencies.
A better approach—holistic architecture
Firms that choose to tackle these operational and regulatory challenges head-on by investing to create and establish an integrated collateral architecture across business lines will have a significant competitive advantage. In a dynamic marketplace where business needs and regulatory requirements are constantly changing, a component-based architecture can be an effective approach. This allows seemingly complex processes to be managed through careful consideration of the distinct business and technology architecture elements of each stakeholder to achieve the appropriate balance for their strategy in an effective manner.
Figure 2
Key components of holistic collateral architecture
Here are some important drivers to consider in your planning:
• Real-time inventory management capabilities across business lines that can be leveraged by both the front and back office (this is a critical component of the strategic architecture, with the key requirement of knowing firm, counterparty and client collateral by jurisdiction)
• QFC trade repository that is integrated across all securities finance transactions as well as derivatives trades that can be linked with positions, margin calls and collateral postings
• Harmonised collateral schedules/legal agreements repository
• Enabling collateral traceability across legal entities with the ability to produce sources and uses of collateral will ensure regulatory compliance, as well as the ability to implement appropriate transfer pricing rules to drive business incentives in the right places
• Utilising optimisation algorithms with targeted analytics can maximise a variety of different business opportunities and most importantly recommend actions through seamless operational straight-through processing
This transition can be difficult for firms as it will need to cut across business and functional silos and it can have significant people and organisational hurdles along with technology challenges. One key point is that these changes don’t need to happen all at the same time and firms can prioritise the approach in a phased manner in line with their pain points and priorities as long as leadership is behind the vision of the holistic architecture. Many firms have started this journey and those who can make demonstrable progress will have a significant competitive advantage in the new era.
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