Collateral Management: Shifting from Cost to Profit Center

Once considered a dreary administrative task, collateral management is moving to high visibility for fund management shops, forced by new regulations to rethink their the use of the assets that back numerous transactions.

Now a target for cost control with the ultimate goal of wringing revenue out of it, collateral management is coming out of the back room.

“Depending on the types of transactions fund managers must collateralize and the types of assets they wish to use, they are considering collateral to be an extension of either the trading desk or the finance department,” explains Mahesh Muthu, associate principal at operational outsourcing specialist eClerx in New York. “Firms will likely have one department or officer with a view across the firm in charge of collateral optimization, but the reporting lines of that department may differ from firm to firm.”

The approach could well depend on the size of the firm. Those with complex and wide-ranging trading activities across a number of counterparties are more likely to set up a collateral optimization desk in the trading unit, working closely with the risk management unit. Firms with simpler trading patterns or ones using external collateral management services may have the function report directly to finance as a component of broader enterprise funding. However, the trend appears to favor oversight by the trading unit, according to some fund management operations specialists.

“We are not seeing buy-side funding desks take on collateral optimization, because it is far more related to investment and trading strategy,” says David Bates, principal at investment operations consultancy Citisoft in Boston. “Therefore, it is unlikely there will be a dedicated chief collateral officer assigned to the job.” Instead, portfolio managers will handle policy and risk functions while the trading desk will secure collateral to manage the overall costs of transactions — particularly those involving derivative contracts.

Such interest by the front-office means at the very least that collateral management is no longer being seen as just a cumbersome costly activity, found a recent survey conducted by buy-side technology specialist Sapient Global Markets. “Knowing just how much collateral to use for which transactions will go a long way to reducing expense,” explains Neil Wright, derivatives director at Sapient Global Markets in Boston.

Cutting Costs for Profit

Just where does profit generation come into play? The answer is obvious to the sell-side firms — custodian banks and broker-dealers — which already offer a gamut of outsourced collateral-management services to fund management shops. Fund managements shops aiming to do the same quality of work on their own to ensure the best use of available collateral for their trades will also see increased profits. They will presumably make better investment decisions, as well as better choices of which central clearinghouse and futures commission merchant to use.

About 30 percent of the 40 fund managers, custodians and other respondents to the Sapient survey either have migrated or plan to migrate collateral management to the front office. And nearly 40 percent say they intend to turn collateral management into a profit making center.

Driving the need for collateral optimization are legislative measures such as the US Dodd-Frank Wall Street Reform Act, its European counterpart European Market Infrastructure Regulation (EMIR) and the pending Basel III Accord, which will all lead to more transactions being collateralized. Fund managers could have dozens if not hundreds of deals in securities lending, repurchase agreements or swap contracts each month. They can ill-afford to strictly use cash, which is the easiest, but most cost-prohibitive collateral option. However, in adding securities — either Treasuries or other liquid bonds — to the collateral mix, the workload becomes more complex and there will always be a place for operational experts.

Collateral management relies on not only juggling available internal assets to back particular deals, but also meeting margin calls with clearinghouses, counterparties and clearing agents under a tight, close-to-real-time schedule. It also naturally includes negotiating disputes with counterparties and clearing brokers over just how much collateral is really required. “Acutally settling collateral management transactions — as in moving cash or assets — to the correct counterparty or location or handling a disagreement or dispute will continue to remain a back office activity,” predicts Wright. The reason: it is still heavily operational and time-consuming requiring a dedicated staff. Front-office specialists need to concentrate on higher decision making investment policies.

Avoiding Bad Consequences

What can go wrong if the firm doesn’t pay sufficient attention to collateral management? When specialists don’t have the technology to maximize or optimize the use of collateral — relying instead on rudimentary home-grown applications or even paper and pencil — they can only hope they have sent the right type of collateral to the right counterparty or clearing broker at the right time. They may send too little, or too much, a relatively minor and often correctable error. In a worse scenario, they may overlook a margin call, which can have disastrous financial consequences.

As a result, it is no surprise that funds are turning to automated applications. The traditional first-come-first-served approach to collateral assignment is no longer adequate, and could quickly lead to a collateral shortfall. Technological advancements are making it easier to migrate some of the critical functions of collateral management to the front-office.

But it isn’t a foolproof transition, cautions Muthu. Optimization engine must be able to aggregate information on the terms of collateral agreements and on any available collateral to do the necessary number crunching. This is not straightforward when there are multiple trade data warehouses and corresponding forms of trade relationship documentation — securities lending, repurchase agreements, exchange-listed derivatives or swap contracts.

“The terms of the collateral agreements might be held in each of those divisions as will the types of available collateral,”explains Muthu. “Siloed data breeds inefficient collateral management.” Fund management firms will have to consolidate their data silos and operating units for collateral management if they intend to centralize collateral management to the front office and leverage a data optimization engine.

While better collateral management decisions should generate cost-savings or even revenues or for fund management firms, not all firms are up to the task. Besides technology investments and back-office support, they will still need collateral expertise at these new desks. Rather than take all this on, some opt to outsource the process to either a broker-dealer or custodian bank, according to Sapient’s study.

What tips the scale in favor of outsourcing? Five US fund management firms consulted by FinOps Report say the decision might simply depend on whether C-level executives, as well as compliance managers, are willing to trust a third-party. “We would need to determine not only the costs involved, but whether we could efficiently monitor the process,” one compliance officer at a US fund manager tells FinOps.”Outsourcing comes with its own can of worms as we maintain legal liability for any errors.”

Regardless of the solution that fund management firms select, it is clear that they will need to do something to cope with the mounting frequency, costs and risks of collateralization. Profits are on the line — losing them or gaining them. And regulators, counterparties and settlement venues will not offer any slack.