Outsourced Collateral Management: A Calculated Choice

When it comes to collateral management for fund managers, why not let someone else do the work?

Considering the cost and administrative burden of this complex processing function, outsourcing sounds like a great idea. There are certainly some mega custodians and other managed service experts only too willing to help out.

However, in this apparent no-brainer, there are a few snags to consider. So cautions a new report from Sapient Global Markets. Outsourcing could be far more expensive than it’s worth, particularly for smaller managers growing their assets.

Collateral management is more than one function. It ranges from simple handling of basic margin calls to complex optimization and transformation of collateral — that is, making the best use of existing collateral and knowing when to trade lower quality collateral for higher quality. Although fund managers may previously have outsourced only a part of these functions, they are now taking a more holistic approach, says Chris Ekonomidis, director of business consulting with financial services consultancy Sapient in New York and one of the authors of the report.

The reason: as new regulations such as the US Dodd Frank Wall Street Reform Act, its European counterpart EMIR, and the global Basel III Accord require more transactions to be collateralized, fund management firms are faced with the need for more technology, workflow management and operational oversight to handle far more margin calls and the possible shortage of high quality collateral. “Compliance officers and chief investment officers are now considering the costs involved with meeting regulatory requirements,” concludes Ekonomidis.

Not only must fund managers comply with new legal measures, but they also have an obligation to provide the highest possible returns to their clients. Increased administrative overhead in collateral management has a direct negative impact on returns, which is why front-office CIOs are being brought into the discussion.

The Sapient report offers a possible methodology for evaluating whether or not to outsource collateral management, based on information gathered from multiple Sapient clients about their decision-making processes.  The resulting calculations are based on a matrix of qualitative and quantitative factors, including the size of the asset management firm, its internal capabilities, the number of deals processed, and whether it wants to outsource optimization and transformation as part of collateral management. The objective is to determine whether the expense of outsourcing is offset by the cost efficiencies gained.

Three basic cost factors of inhouse operations are: use of internal personnel, costs for workflow and IT infrastructure, and opportunity costs, such as the need to pull staffers from other units in a crunch. In particular, if regulatory updates or investors’ changes show up in clusters, the core staff of collateral management experts could be overwhelmed by the workload.

The potential burden created by frequent changes of regulatory requirements and investors’ guidelines ranks high on Sapient’s list of factors to consider when deciding whether to keep the collateral management process in-house or outsourced. Other significant criteria in the decision to outsource are: the need to maintain accuracy in data exchange among multiple internal applications and the risk that the third-party provider might go bust or need to be replaced. Further down the list are finding and evaluating service providers.

Juggling the Numbers 

To show how the math works, Sapient describes a hypothetical asset manager with US$30 billion in assets managing 300 funds with an average value of US$100 million. About 60 percent of the fund manager’s assets are of good credit quality and 40 percent are of lower credit quality. If collateral optimization and transformation are not considered, the model finds that it costs $2,461,768 to do collateral management in-house and US$2,540,814 to outsource it.

Here is why the numbers are so close, according to Sapient: Even with outsourcing, internal IT systems are still needed to handle regulatory reporting and audit requirements. Full-time employees are also needed — one for each 150 agreements. As assets under management rise, so do both the total fees for outsourcing and the number in-house coordinators to manage the outsourcing relationships — a cost that can disproportionately affect smaller, but growing firms.

When consideration of outsourced optimization and transformation is added to the calculation, the complex number-crunching really heats up. Among other factors added to this calculation are the steepness of interest rate curves and credit spreads. In general, the steeper the interest rate curve and the higher the credit spread the greater the cost reductions offered by optimization and transformation. Overall costs for outsourcing can also decrease by as much as 25 percent for a fund manager handling a lot of funds.

Sapient predicts that break-even for outsourcing without collateral optimization would show up at about US$25 billion in assets, reflecting a net collateral balance of US$1.875 billion or 750 collateral agreements to handle. The break-even point would be far less — at about $17 billion in assets under management, reflecting a net collateral balance of US$1.275 billion or about 510 master agreements — with the benefits of collateral optimization and transformation. At the breakeven point, there is no financial advantage to outsourcing. Above that, the case for outsourcing gets stronger.

What are other experts advising for outsourcing decisions? Numbers are good, but just for starters. Michael Barrett, vice president for financial services consultancy Genpact in New York, points out that the decision may also depend on investment strategy. “Fund management is a very broad category,” he says.”Managers of us 1940 Act funds — such as mutual fund complexes — have far easier collateral management requirements and may keep more in-house, while hedge funds with complex investment strategies might opt to outsource collateral management to their fund administrators or prime brokers.”

Mahesh Muthu, associate principal at operational outsourcing specialist eClerx in New York agrees that a rigorous cost-benefit analysis has to be part of the decision. “The methodology needs to be solid, even if the specific firm’s circumstances require more or different inputs.”

All Those Extras

However, he also suggests other soft-dollar or unquantifiable considerations, such as whether the service provider’s operations support the firm’s regulatory reporting requirements and whether oversight of the third-party can be consistent with regulatory mandates. Both Dodd-Frank and EMIR demand that asset managers can prove their oversight of operational procedures such as collateral management. EMIR also requires fund managers to report on the collateral and its value used in each transaction — figures which need to be in sync with the books of the service provider.

What do fund managers think of Sapient’s methodology? “It’s a useful approach, but not applicable to all firms,” cautions one operations director at a US fund management firm. “It will be best used where a higher volume of bilateral or uncleared deals are creating a need for collateral optimization and transformation.” New regulations will require that even swap deals, which cannot be processed through a central clearinghouse, to post far more collateral than is currently the case.

Another buy-side operations manager points out that preferential pricing is another factor that should be considered in the calculation. “Fund managers might get a better price for adding on collateral management to an existing outsourcing relationship than they’d have to pay a standalone service provider.”

Regardless of whether Sapient’s model could be fine-tuned or customized for certain types of firms, the methodology offers asset managers a foundation, say all five fund management firms consulted by FinOps Report. That means chief investment officers and chief finance officers could have a leg up on what promises to be a complex decision-making process.