For firms that trade financial instruments that include counterparty risk, all signs point to more complex compliance related to collateral obligations. Recent regulatory changes mandate that firms trading such instruments – derivatives, repos, forward-settling mortgage-backed products, for example – must pledge more assets as collateral. In addition, there are further regulatory challenges that will phase in during the next few years regarding already complex margin requirements. Investors need to increase the efficiency with which they use their assets and more readily identify potential opportunities. Institutional Investor spoke with Jud Baker, Derivative Product Manager at Northern Trust, which in its relationships with asset managers often provides collateral-related services and insights.
What has been happening – and will happen – in the regulatory arena that is creating collateral-related challenges for the buy side?
About 18 months ago we went through a wave of global regulations that required firms to adhere to what became known colloquially as the “uncleared margin rules for derivatives.” These regulations require that a credit agreement is in place which mandates that firms conform to certain standards and have an operational process in place that determines if and when collateral needs to be exchanged to cover variation margin. That was largely a best practice anyway, but in the next phases of this regulatory transition, firms with significant volumes of uncleared derivatives will have to pledge initial margin to each other, and that’s above and beyond any kind of collateral that they’ve pledged in the past.
Is the impact the same for the sell and buy sides?
Initial margin has impacted mainly the top 20 or 30 dealer organizations on the sell side, but it’s also impacting several very large buy side firms. There’s a five-year phase-in period, ending in September of 2020, where each year the net gets a little wider and captures more of the buy side. That’s one more element of the liquidity crunch firms will be facing.
So how will firms need to respond to the liquidity crunch you describe?
We have already seen liquidity pressures as a result of mandatory variation margin exchange and the central clearing of OTC derivatives. Now, as we get closer to the end of the phase-in period in 2019 and 2020, there will be bigger concerns around liquidity management for many organizations. They’ll have to set aside more assets in the event they need to collateralize their derivative transactions. Additionally, the new regulations mandate same day settlement of collateral calls. Firms will have to quickly determine which securities meet the eligibility rules, and some may find it burdensome to access cash or securities on such short notice.
That sounds like it has the potential to be a tall order. How can firms keep up with it on a daily basis?
It’s important for firms to establish a holistic view across their assets and margin product silos, and establish what we call an “enterprise inventory view.” Because we act as the middle and back office for many of our asset manager clients, we have an overall view of the inventory of our clients’ assets – and having that view is the first step in determining the optimal array for pledging collateral. Without that view, you run the risk that you’re not using your assets in the most efficient manner. For example, you may pledge cash or bonds to one broker, whereas you may have benefited more if you had instead pledged those assets with a different broker for a different type of credit agreement. As another example, you may pledge a high-quality treasury bond with one firm, but what you have remaining doesn’t meet the eligibility rules for a different credit agreement – it may have been better if you had flipped it around and pledged it to the more stringent counterparty as opposed to the one with less restrictive collateral requirements. Whereas in the past margin calls may have been viewed sequentially, it is really optimal that they be viewed in totality. The ability to holistically determine the most efficient use of assets in meeting the daily collateral requirements will help firms considerably.
How do you take on board the clients’ goals and customize collateral optimization solutions for them?
We spend time with the client to understand what’s important to them, and then we build routines, algorithms, and calculations to fit their needs. We work to understand our clients’ strategies and how they can best maximize the use of their assets. For example, some of our clients are active in the repo markets, and they may be able to earn a better return on their assets if they repo out a subset of their portfolio. In that case, we might try to protect certain securities subsets from being tied up as collateral. This is all done on a systematic basis using Northern Trust’s collateral optimization service. Our automated workflow tool helps us manage complex rules and gives us the ability to effectively execute a much larger volume of efficient collateral movements each day.
How often do a client’s goals change, perhaps requiring an adjustment to an algorithm?
That’s a good question. We have designed our capability to be flexible so we can accommodate our client’s needs if their goals change. We establish one or two primary algorithms for the client which can be layered based on different priorities or attributes. If goals change, we can adjust the algorithm based on their new priorities. We also understand that clients may have different views on how to determine efficiency. The ability to rapidly consume, integrate, and process market or client-provided data as an input to algorithm-based collateral selection is an important aspect of our solution.
Aside from taking something very complex and making it simpler and more efficient, what are some of the other benefits for clients?
From a client’s perspective, there are three general benefits: credit risk reduction, liquidity management, and identifying the potential for true financial gain. If the client is better off repo-ing out a bond, reinvesting the cash proceeds, and earning more on that interest, that’s a better play than us taking that same bond and pledging it as collateral. Efficient selection of assets to cover margin calls can result in a greater retention of assets which may then be used to raise liquidity or lent to increase returns. At Northern Trust, we feel that offering a flexible ability to optimize the asset selection in order to meet client collateral requirements is a timely complement to our industry leading collateral management service offering.
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