Rising interest rates: new hurdle or considerable opportunity?
16 August 2022
While collateral optimisation has always helped to minimise funding and liquidity costs, the new rate environment is creating even greater urgency for optimisation to drive P&L benefits, says Todd Hodgin, global head of product development at Transcend
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To combat inflation and a potentially overheating economy, the Federal Reserve has begun communicating plans to aggressively raise interest rates throughout 2022 and 2023. The Fed began with a modest increase of 0.25 per cent. However, market professionals are estimating the likelihood of as many as six additional rate increases in 2022 to move monetary policy toward a more neutral rate environment. Similar interest rate increases have occurred in other industrialised economies as inflation continues to grow globally. Market participants are now increasingly looking for new financing and trading efficiencies to get ahead of additional funding costs and the risk of stunting profitability and growth. While collateral optimisation has always helped to minimise funding and liquidity costs, the new rate environment is creating even greater urgency for optimisation to drive P&L benefits.
The impact on financing collateral
The first impact of potential changes in the rate environment are increases in absolute interest rates and the overall costs to finance collateral. Simply put, the cost of borrowing cash will be more expensive than it has been in years and will increase the overall costs to support certain trading and customer financing strategies. Banks and broker dealers have enjoyed a period of relative calm for balance sheets. However, as central banks step away from asset purchases, there will be new supply that needs to be financed in the market. As a result, firms that are inefficiently utilising their collateral and unsecured funding risk impacting their P&L.
In addition to increases in absolute rates, the new environment can mean it will be more costly to support long-term funding and financing lower-quality collateral. While there are various projections for future funding costs as a result of rate increases, the premia for longer term funding could increase over time. Additionally, funding spreads for lower quality collateral could increase and create a more punitive environment for financing non-government collateral. Volatility of certain asset classes, including corporate bonds, may act as an accelerant for credit spread widening. These potential changes to term premia and spreads would impact certain portfolios and trading strategies, impacting the funding costs and P&L of those businesses.
Finally, rising interest rates can also influence firms’ risk tolerance and subsequently their investment choices, ultimately causing certain sources of funding to be less attractive, less stable and harder to manage.
An opportunity for optimisation
With increasing absolute rates, spreads and term premia, the cost of financing businesses is set to be higher and more volatile. The goal of an effective collateral optimisation strategy is to help market participants extract the greatest value from their financial resources; as such, there is a large opportunity for collateral optimisation to maintain and increase profitability. By evaluating the costs of financing various collateral types with differing qualities, an optimisation strategy will help firms more strategically select the collateral that meets a counterparty’s eligibility requirements while minimising liquidity and funding costs to the business. With higher costs to consider, the potential savings from a collateral optimisation strategy will materially increase.
Optimisation potential in practice
Transcend has seen firms realise significant benefits from implementing collateral optimisation across their financing and margining activity. By strategically implementing end-to-end solutions that incorporate funding and capital costs, collateral eligibility and operational costs into their optimisation solutions, firms have been able to automate the allocation of preferred collateral to these exposures and obtain millions in annualised saving across financial, efficiency and risk factors.
In an environment of increasing absolute rates, wider spreads and higher costs of unsecured funding, these firms are poised for even greater cost savings. Transcend’s research and analysis team found that, based on conservative rate assumptions, potential savings from optimisation could increase an additional 16 per cent to 250 per cent.
The importance of technology
The value of being able to optimise vertically or horizontally across collateral silos under a new rate environment is clear. However, achieving collateral optimisation can be difficult without the right partners and tools. While developing a cross-product collateral optimisation solution in house can take several years, market participants need to implement an optimisation solution now before rate increases impact profitability. As a result, more firms are looking to partner with companies like Transcend to more quickly mitigate the impact of a new rate environment.
However, not all optimisation solutions are the same. With a holistic optimisation platform built on enterprise inventory that considers multiple cost dimensions, market participants can more effectively understand and improve the utilisation of collateral in totality, therefore, limiting unnecessary financing and liquidity costs. A single optimisation solution for all asset classes, triparty providers and margin needs will deliver significantly higher returns, and ultimately will be a firm’s competitive financial edge. However, scalability is also crucial to ensuring both the immediate and long-term value of optimisation results. By leveraging technology that can optimise decisions within a specific product or business line first, with the opportunity to expand to multiple divisions over time, clients can realise a quicker time to value without limiting future potential.
Lastly, an effective optimisation solution should enable straight-through processing. Delivering the collateral that maximises cost reduction could require complex collateral mobilisation activities. As a result, any optimisation solution needs to be able to automate and seamlessly execute movement recommendations to limit operational friction and roadblocks.
The impact on financing collateral
The first impact of potential changes in the rate environment are increases in absolute interest rates and the overall costs to finance collateral. Simply put, the cost of borrowing cash will be more expensive than it has been in years and will increase the overall costs to support certain trading and customer financing strategies. Banks and broker dealers have enjoyed a period of relative calm for balance sheets. However, as central banks step away from asset purchases, there will be new supply that needs to be financed in the market. As a result, firms that are inefficiently utilising their collateral and unsecured funding risk impacting their P&L.
In addition to increases in absolute rates, the new environment can mean it will be more costly to support long-term funding and financing lower-quality collateral. While there are various projections for future funding costs as a result of rate increases, the premia for longer term funding could increase over time. Additionally, funding spreads for lower quality collateral could increase and create a more punitive environment for financing non-government collateral. Volatility of certain asset classes, including corporate bonds, may act as an accelerant for credit spread widening. These potential changes to term premia and spreads would impact certain portfolios and trading strategies, impacting the funding costs and P&L of those businesses.
Finally, rising interest rates can also influence firms’ risk tolerance and subsequently their investment choices, ultimately causing certain sources of funding to be less attractive, less stable and harder to manage.
An opportunity for optimisation
With increasing absolute rates, spreads and term premia, the cost of financing businesses is set to be higher and more volatile. The goal of an effective collateral optimisation strategy is to help market participants extract the greatest value from their financial resources; as such, there is a large opportunity for collateral optimisation to maintain and increase profitability. By evaluating the costs of financing various collateral types with differing qualities, an optimisation strategy will help firms more strategically select the collateral that meets a counterparty’s eligibility requirements while minimising liquidity and funding costs to the business. With higher costs to consider, the potential savings from a collateral optimisation strategy will materially increase.
Optimisation potential in practice
Transcend has seen firms realise significant benefits from implementing collateral optimisation across their financing and margining activity. By strategically implementing end-to-end solutions that incorporate funding and capital costs, collateral eligibility and operational costs into their optimisation solutions, firms have been able to automate the allocation of preferred collateral to these exposures and obtain millions in annualised saving across financial, efficiency and risk factors.
In an environment of increasing absolute rates, wider spreads and higher costs of unsecured funding, these firms are poised for even greater cost savings. Transcend’s research and analysis team found that, based on conservative rate assumptions, potential savings from optimisation could increase an additional 16 per cent to 250 per cent.
The importance of technology
The value of being able to optimise vertically or horizontally across collateral silos under a new rate environment is clear. However, achieving collateral optimisation can be difficult without the right partners and tools. While developing a cross-product collateral optimisation solution in house can take several years, market participants need to implement an optimisation solution now before rate increases impact profitability. As a result, more firms are looking to partner with companies like Transcend to more quickly mitigate the impact of a new rate environment.
However, not all optimisation solutions are the same. With a holistic optimisation platform built on enterprise inventory that considers multiple cost dimensions, market participants can more effectively understand and improve the utilisation of collateral in totality, therefore, limiting unnecessary financing and liquidity costs. A single optimisation solution for all asset classes, triparty providers and margin needs will deliver significantly higher returns, and ultimately will be a firm’s competitive financial edge. However, scalability is also crucial to ensuring both the immediate and long-term value of optimisation results. By leveraging technology that can optimise decisions within a specific product or business line first, with the opportunity to expand to multiple divisions over time, clients can realise a quicker time to value without limiting future potential.
Lastly, an effective optimisation solution should enable straight-through processing. Delivering the collateral that maximises cost reduction could require complex collateral mobilisation activities. As a result, any optimisation solution needs to be able to automate and seamlessly execute movement recommendations to limit operational friction and roadblocks.
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