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Outsourcing Collateral Management Can Be a Mixed Blessing

As regulations grow stronger, asset managers must weigh the potential benefits and drawbacks of letting third parties manage collateral for them.

Collateral management outsourcing is on the rise as asset managers seek to off-load this complex task and take advantage of custodian banks’ vast securities holdings. Now there’s a new incentive: regulations designed to make financial markets safer by boosting the quantity and quality of collateral posted to support trades. The most important of these rules govern over-the-counter derivatives, including the $81 trillion OTC foreign exchange market, which most asset managers with overseas exposure use.

Last September the Basel Committee on Banking Supervision and the International Organization of Securities Commissions issued their final framework outlining collateral requirements for OTC derivatives. The framework requires traders to put up margin commensurate with counterparty risks; eligible collateral includes cash, high-quality government and corporate debt, covered bonds, equities and gold.

Although they aren’t legally compelled to do so, national regulators typically adopt the Basel Committee’s proposals. But the timetable for adoption is uncertain, thanks largely to the banking industry’s fierce lobbying over the rule changes.

Tighter collateral requirements will be all the more effective because regulators are pushing at an open door in the case of asset managers. “We are now living in a more risk-averse environment,” says Florence Fontan, head of asset management clients at BNP Paribas Securities Services in Paris. “Anyone taking risk by making a trade wants to have collateral to mitigate that risk.”

The biggest question for asset managers looking to minimize costs and maximize efficiency: How much collateral management should they outsource? The current trend is toward outsourcing, says James Economides, co-founder and director of ?Amaces, a London-based firm that helps clients select and monitor custodians. Last year, for example, British Airways’ two pension funds appointed Bank of New York Mellon Corp. to provide collateral management for their OTC derivative holdings.

The advantages of outsourcing include letting someone else worry about regulatory and other details. “A lot of asset managers don’t understand the complexity and the workload of collateral management,” says BNP Paribas’s Fontan, who warns against underestimating those duties. In particular, she points to what she calls a tsunami of constantly changing regulations.

Because most collateral managers are custodian banks, they can also draw on trillions of dollars’ worth of securities when providing collateral transformation, the substitution of one asset that meets collateral requirements for another that doesn’t. This service allows an asset manager specializing in equities, which are ineligible as collateral for many trades, to lend them to the custodian bank in return for low-risk government bonds, which are eligible for all trades.

Amaces’ Economides thinks this nascent business, which he describes as opaque, is set to grow substantially. But it’s expensive: Transformation can cost clients up to 50 basis points of the value of the collateral provided, he estimates.

Other experts question the value of more outsourcing. One major drawback is the minimum annual fee of about $100,000 that some collateral managers charge, regardless of volume. Service providers also cite administrative headaches and risk management perils. Ted Allen, London-based vice president of capital markets collateral management at U.S. I?T giant SunGard, which supplies collateral management technology to banks and asset managers, says the latter entities can never completely outsource.

“Asset managers still need oversight because you should never outsource what you don’t understand,” Allen explains. “If you don’t understand collateral management, how can you verify that what should be done is being done?”

Then there’s the chance that asset managers could suffer another event like the 2008 collapse of Lehman Brothers Holdings, which left them scrambling to find new collateral for their trades after Lehman securities pledged as collateral suddenly became worthless. “If your collateral manager has 50 or 100 clients and you’re not one of the biggest, you might not be first in the list of clients that the provider serves,” Allen contends. Collateral agents dispute that claim. “We have an obligation, at least in terms of code of conduct and even in some cases for regulatory reasons, to treat all our clients fairly and with the same priority,” BNP Paribas’s Fontan says.

A middle way to keep external collateral managers on their toes is by taking on two or three. But David Myers, a London-based partner with Deloitte’s U.K. financial services and technology consulting practices and leader of the firm’s British capital markets business, thinks such a strategy could be counterproductive. “If you start to introduce too many organizations, I suspect that your fees are going to outweigh your benefits,” Myers says. • •

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