A guide to collateral management

What is collateral management?

Although post-financial crisis regulation was targeted at OTC derivatives, both securities lending and repurchase agreements (repos) have been affected by the changes made to the way collateral is administered and posted. It required a different approach along with the necessary upgrade to systems and processes.

Overall, collateral management is the process of managing assets pledged by one party to another to mitigate credit risk and minimise the effects of potential default. Key players include banks, insurance companies, broker-dealers, pension funds, hedge funds, large corporations, and asset managers.

In securities lending, a fund temporarily lends securities that it owns to an approved borrower in return for a fee. The borrower is required to provide sufficient collateral-in the form of either cash or securities-to compensate the fund if the loaned securities are not returned in the agreed timeframe, subject to certain counterparty and liquidity risks. Repo is also a form of collateralised lending whereby a basket of securities acts as the underlying collateral for the loan. Their legal title passes from the seller to the buyer and returns to the original owner at the completion of the contract.

Collateral management is not a new concept but historically it was viewed as mainly a back and middle office function. This changed during the global financial crisis in 2008 when financial institutions realised the crucial role collateral played in providing access to much needed liquidity and funding, particularly in times of extreme market stress. It was propelled to front office on the back of the raft of rules designed to bolster the financial infrastructure’s defences.

One of the most notable pieces of legislation in this area being the Basel Committee on Banking Supervision (BCBS) and the International Organisation of Securities Commissions’ (IOSCO) Margin Requirements for non-centrally cleared derivatives. Also known as the Uncleared Margin Reform or UMR, the aim was to both reduce systemic risk and promote centralised clearing of derivatives.

The implementation road has been long with regulators setting out the UMR’s global policy framework and a six-year staggered timetable in 2013. Thresholds were determined by the Aggregate Average Notional Amount (AANA) of non-cleared derivatives and calculated over a three-month period in each year, as provided under the relevant applicable regime. The rules officially kicked off in 2016, with the first cluster of four of primarily large sell-side and buy-side firms on aggregate ANNAs greater than $3tn, $2.25tn, $1.5tn and $750bn respectively. Despite their size, they were the smallest cohort as those in category 5 and 6 had over 1,000 constituents. They went live in 2021 and 2022 with respective ANNAs of over $50bn and $8bn.

In general, the rules were generally applied consistently across the main jurisdictions in Europe, Asia-Pacific and US. Physically settled forex forwards and swaps were excluded as well as the exchange of principal on cross-currency swaps. However, there were regional differences. For example, equity options were out of scope in the US, while in Europe the exemption for these securities was extended for two years to January 2026 as proposed by the European Supervisory Authorities.

Crunching the numbers

Unsurprisingly, sophisticated sell-side and buy-side firms were familiar with the inner workings of collateral management and had internal resources to deploy. This was not the case with many of the category 5 and 6 asset managers and hedge funds who never had to exchange and segregate IM, a risk-based calculation which is designed to serve as a buffer throughout the life of a transaction, protecting one party against the default of the other. (ISLA link). They were accustomed to variation margin (VM), a mark-to-market value which is used to capture changes in unrealised profit or loss on the trade. It is typically transferred daily using the previous day’s mark-to-market value of the asset. Historically, VM was posted as cash, whereas regulatory IM is generally non-cash collateral.

The elevated status of IM meant that new models for calculations had to be developed. After much debate and discussion, the two that emerged were a table-based construct known as the Grid, and the Standard Initial Margin Model (SIMM) – the International Swaps and Derivatives Association internal model (BNPP link). Although they co-exist, market participants have seemed to coalesce around ISDA’s version because it is more efficient than the table-based method since it offsets the risks in a derivatives portfolio. In addition, it is a consistent and transparent method for determining the amount of collateral that counterparties must post to cover the potential future exposure of their trades. This has not only facilitated the implementation of the calculation process but also avoided inextricable disputes on the IM numbers.

Impact of UMR on securities lending and repo in the use of collateral

Although OTC derivatives are at the centre of the UMR, there have been knock-on effects in the securities lending world. For example, a large number of buy-side firms in the latter groups did not have a Treasury department and have increasingly turned to these programmes to substitute and enhance their collateral. (ISLA link). In general, the collateral in securities lending can be either other securities such as equities or cash, while in the repo market, which is also being used to gain access to liquidity, bonds and other fixed-income instruments are preferred.

This is particularly true in Europe where the International Capital Markets Association’s (ICMA) semi-annual survey of the European repo market estimates government bond collateral accounts for over 90% of EU-originated repo collateral. In the US, Treasury securities comprise roughly two-thirds, while the rest is in government-guaranteed Agency debt and Agency Mortgage-Backed Securities (MBS). (ICMA link).

ICMA said that lesser quality government bonds, often dubbed credit repo, are also deployed. These are typically supranational bonds issued by institutions such as the World Bank, plus sovereign and agency bonds. Private sector assets form the smallest sector of the repo market because they tend to be riskier and much less liquid than government bonds, although higher yielding. They include:

• Corporate bonds, typically senior unsecured debt issued by investment-grade banks and large non-financial companies.
• Equity, especially baskets reproducing market indexes such as the FTSE-100, CAC and DAX. The use of equity as collateral has increased since the financial crisis, during which the asset class performed well as collateral in terms of the continuous availability of tradeable prices.
• Covered bonds such as pfandbrief have been increasing in popularity as collateral, in part because regulators have signalled its acceptability to meet regulatory liquidity ratios. They are secured by pools of public loans or mortgages held on the balance sheet of the issuer but ring-fenced in statute by special public laws. They are issued in countries such as Germany with stronger banking sectors.
• Mortgage-backed securities (MBS), such as residential MBS (RMBS), which are held largely off the balance sheet of the mortgage issuer and ring-fenced contractually within bankruptcy-remote special purpose vehicles (SPV). To be widely accepted as collateral, they need to be AAA-rated.
• Other asset asset-backed securities (ABS) and re-securitisations such as collaterised debt obligations and loans (CDO and CLO) as well as credit linked notes CLN), which are held off the balance sheet of the originator of the underlying assets and ring-fenced contractually within bankruptcy-remote SPV. Most investors require a AAA-rating on such assets.
• Money market securities such as treasury bills and, in some countries, certificates of deposit (CD) and commercial paper (CP). However, CDs are not always popular because they represent an exposure to commercial banks and CP issues are difficult to use as collateral because they tend to be relatively small.

Tri party agents come into their own

The more stringent regulatory landscape has sharpened the industry focus on cost-effective, efficient and profitable solutions to segregate, manage and optimise their collateral activities across OTC derivatives, repos and securities lending. This has led to a review of the providers, systems and technology on offer. All agree that automation is the only way forward as firms can no longer afford the inefficiencies or human error tied to the heavy dependence on manual processes.

There is also a recognition that these distinct functions can no longer exist in their own silos. Barriers have to be broken down and operational tasks applied throughout the different product lines, whether it be trade data capture and validation, margin calculation and call workflow, collateral booking and optimisation, settlement, reporting, and collateral inventory management.

In the past, many smaller to mid-sized players employed third-party structures for their collateral management. It is a less expensive proposition whereby a large chunk of the operational workflow involved in collateral selection and settlement was done in house. This meant that firms and their counterparties agreed the IM call amount and then the collateral to be pledged, before instructing settlement to the custodian. https://www.cmegroup.com/education/articles-and-reports/triparty-third-party.html)

However, the introduction of IM injected a new, more complex layer into the collateral management dynamics. It not only created a funding drain for buy-side firms by consuming collateral that had previously not been required, but also new operational costs. (https://finadium.com/buy-side-firms-triparty-and-a-new-look-at-generating-alpha). As a result, outsourcing became an increasingly attractive options with the tri-party model, a well-established feature in the repo world, taking centre stage.

The cost may be higher but investing in the necessary resources and technology also comes at price. The main advantages, according to BNY Mellon, are centralised across a network of trading counterparties, there is greater depth in the inventory pool and liquidity is generated from securities financing relationships.

Firms may want different services but the most comprehensive integrated collateral management packages cover receiving and matching client instructions across various types of transactions to valuing collateral assets and calculating net exposures. Also on the list is real-time selection and collateral allocation from the available inventory plus event and substitution management. In addition, they take responsibility for ongoing monitoring for collateral sufficiency, including daily mark-to-market as well as reporting to both parties of the trade.

Equally as important, the tri-party model provides a holistic and single eco system across OTC derivatives, securities lending and repo. This is seen as a more efficient method of sourcing, optimising and delivering collateral. For example, research from Finadium shows connecting repo and UMR in tri-party can produce a financial benefit of between 10-25 basis point. It cites an example of leveraging tri-party repo to transform US Treasuries into cheaper UMR-compliant securities compared to posting US Treasuries on a bilateral basis.

The Finadium research also highlighted opportunities to further whittle down costs as part of a structural review of a buy-side’s collateral business model. For instance, it may be more profitable to deliver US equities as collateral, reserving hard to borrow securities to lend to brokers for short sale covers. This also allows expensive US Treasuries to be allocated to cleared Fixed Income Clearing Corp (FICC) repo by leveraging a broader basket of collateral within a tri-party agent configuration.

While many custodians offer the third-party structures, there are a handful of tri-party agents. In Europe, Clearstream Bank Luxembourg, Euroclear Bank, Bank of New York Mellon, JP Morgan and SIX SIS are the main players. In the US, BNY Mellon is the single so-called ‘clearing bank’, which is an industry utility providing US Treasury settlement clearing and tri-party management services. JP Morgan ceased to be a ‘clearing bank’ in 2018 but remains a tri-party service-provider.

Conclusion

The UMR has shaken up the world of collateral management not just for OTC derivatives but also for securities lending and repo. IM is a new concept for many small to medium-sized firms and they are turning to the latter markets to raise and enhance their collateral. This has meant a review of internal processes and systems with many opting to outsource collateral management to a tri-party provider. It not only enables them to focus more on their core activities but also gives them a much-needed complete picture of these different product lines, saving both time and money.