Representatives from the buy side met with consultants, a lawyer and a bank provider to discuss how regulation affecting OTC derivatives will shape the future of buy-side collateral management.

Citi Buy-Side Collateral Management Roundtable

Discussion

Hugo Can we start by laying out the current collateral requirements arising from the new rules on OTC derivatives? Guy?

Guy Taking the margin requirements as presented in the latest BCBS-IOSCO report, both what’s required and the timeline for compliance are generally manageable due to the proposed thresholds and phasing. Significantly, much of the impact in the early stage will be on variation margin and not — as we had first thought — initial margin. This will have considerable knock-on effects. Funds will be judged as financial counterparties and thereby covered by variation margin requirements irrespective of trade volumes. This will have significant implications for prime brokers, which will inevitably mean they will look to pass the costs associated with two-way variation margin on to customers.

Nick I’d note that even in the latest BCBS-IOSCO report there is a lot that is still uncertain from an implementation perspective. Almost every paragraph has some room for interpretation. For example, the definition of hedging for rehypothecation purposes is still unclear, as are the options for threshold allocation across group entities.

Mark But these issues won’t hold up implementation: there is so much political pressure to implement these measures, it would be unwise to assume that the timelines will be pushed back.

Hugo How will these new collateral requirements affect buy side firms?

Tim A lot will depend on the type of fund: typical fixed-income, credit or equity portfolios in comparison to real-estate portfolios or pension funds will face very different challenges under the new rules. In general, we have lots of ideas about how to address the challenges. But we haven’t put them into practice yet: current priorities — notably reporting requirements — are more pressing. I think that in three to four months’ time we’ll start to focus more heavily on this and look to advice from external parties such as legal firms and investment banks with whom we have strong relationships. Even then it will be hard to fully engage all our portfolio managers because things won’t really bite for some of them until 2015 and beyond.

Mark Whether through initial or variation margin, it is clear that the cumulative effect of the new rules will be that we will be posting far more margin in three or four years than we are today. That’s going to have a number of consequences. For example, getting from today, with collateral posting often operating with a two-day settlement period, to a place where clearing houses are demanding collateral intraday — that’s a big job. But if you don’t want to build up big cash buffers, which will drag on performance, collateral will have to be far better optimised.

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Hugo How important will pension funds be in providing the high-quality collateral needed by other participants for central clearing?

Roger Pension funds will only engage in the transformation trade if they are rewarded for the risks, since lending government bonds and taking in equity collateral is not going to help their risk profile. Insurers, another potential source of this collateral, are reluctant to be involved because Solvency II would punish them for the inferior collateral they would be left with. In terms of pricing, therefore, the 102 or 105 pricing model for this type of collateral seems too low. The formula has been around for years so it is unlikely to have a statistical basis. But an uplift to 120 or 125 could be more realistic. In addition, the agent lender must continue to provide indemnification. This is getting costlier for them, since banks must put capital behind this guarantee under Basel III rather than, as previously, placing it off balance sheet. Currently some agent lenders will indemnify against, say, equity collateral, whereas others will not.

Mark Stock lending is already a good source of revenue for us. However, clearly our priority will be ensuring that we have enough collateral to meet our own margin obligations. If we and other existing liquidity providers hold back the amount of stock lent out, this could exacerbate any industry-wide shortfall.

From left to right. Back row: Tim Harris, Associate Director, Alternatives and Derivatives, Hermes Fund Managers; Hugo Cox, Interviewer; and Nick Newport, Managing Director, InteDelta. Front row: Roger Fishwick, Chief Risk Officer, Thomas Murray Data Services; Rajen Shah, Global Head of Collateral Management and EMEA Head of Securities Finance, Citi; Mark Ryan, Derivatives and Counterparty Risk Manager, Aviva Investors; and Guy Usher, Head of Derivatives and Structured Finance, Field Fisher Waterhouse.

Hugo What progress are buy-side firms making to ensure they are optimising the sourcing of collateral from within their portfolios?

Tim Full end-to-end collateral optimisation is still something of a utopia and remains grounded in the back office. When we get into clearing next year, CCPs will begin to differentiate themselves with how they can support it. The outsource providers and custodians are developing systems that will enhance our view on where our collateral is and where we may be able to optimise, but they don’t yet integrate perfectly into our front-end platforms. It’s still a black-box scenario, but this will change: we’re now having these conversations with our outsource providers and custodians more and more.

Mark Currently, we typically just use cash. When you want to use securities, the plumbing involved gets much more difficult. Portfolio managers are reluctant to have too much of their time taken up with the logistics of recalling securities before they sell them. Our systems will need to improve in the future to make this a more seamless process.

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Rajen Shah, Global Head of Collateral Management and EMEA Head of Securities Finance, Citi.

index-based fund that needs to identify where its assets are globally and how to move them to the CCP. At the other more complex end, a fund needs access to a range of parameters that affect how to best source collateral. Where a fund has collateral that is of a higher quality than that required for the trade, it may be able to lend out this collateral, thereby receiving both the eligible collateral it needs and additional revenue. In other cases, it may be that the costs of sourcing collateral for a trade makes it uneconomical and an alternative investment strategy needs to be explored.

Guy I wonder whether most buy-side firms could deliver the level of operational sophistication needed to optimise collateral in that way?

Nick Yes, the complexity is not in the maths but in understanding the availability of your inventory, where it’s sitting and where it can be used.

Roger Across hundreds of different accounts in many different entities, each facing different specific restrictions, many funds cannot engage in transformation trades since they are prohibited from taking in and investing cash or equity collateral or from pledging assets, for example.

Raj The task for buy-side firms is not so different to the one that banks have already addressed. Banks have multiple desks with varying obligations and demands and have built a layer of collateral management, closely tied to Treasury, above that. Buy-side clients are now looking to set up a similar function working across portfolio managers. We help them design these and

Hugo What might a future optimisation solution look for an illiquid portfolio like a real-estate fund?

Tim The basic scenario seems to be building a buffer and modelling the biggest market move that it can absorb before the portfolio needs to be changed. Then typically looking to the repo market for generating cash and eligible assets to meet the variation margin and or initial margin. We have concerns, of course, about performance impact and about the repo market – notably whether we can get access to it in times of a stressed market. We are still not totally clear about how such a portfolio would generate the cash or assets to meet margin requirements without adapting. This means we’re starting to look at alternative OTCs or non-OTC products to gain the required exposure – structured note-type products in the case of real estate, for example. There is not a one-size-fits-all solution, and some portfolios will need to change more than others.

Hugo What are other people hearing from buy-side clients in terms of demands for optimisation?

Nick Both terms – transformation and optimisation – can mean different things to different participants. Most participants are aware that they’ll need to improve the process by which they select and deliver collateral. But the main challenge will be for funds that don’t have a significant cash allocation and must raise collateral from their assets in other ways – like Mark’s real-estate example. When we surveyed the market, asking whether the buy side perceives a need for optimisation or transformation services, it typically answers “yes” for those particular types of funds that have the biggest issues from an asset-allocation perspective. From a solution perspective, first people will look internally to source the required assets, and then, if this is not possible, to external providers, such as providers of collateral transformation trades. And in terms of when they will require solutions, the point when collateral starts determining fund holdings will be the time when the investment case becomes compelling.

Guy We’ve seen interest in optimisation limited to the big alternatives managers, who typically have a single, large master fund rather than many smaller ones. They are already structured more like banks when it comes to collateral management, and can afford to have a designated person or team in place responsible for picking the assets most cost-effectively and ensuring that they can be called back when needed. Interestingly, banks don’t yet seem set up to offer siloed collateral services to clients.

Raj Up to now, there hasn’t been a demand for these services. This is changing now: we and our competitors are developing the optimisation solutions required to automate these processes for clients. These solutions vary, depending on client needs. At one end, there’s an

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provide a second layer joining that to the services we provide. So our securities finance traders’ role will shift beyond agency lending to help clients understand how to best meet their own collateral needs. This might be with a transformation trade that delivers the required collateral for margining and a return. In this respect, security lending and collateral management are moving towards the front office for providers and their clients.

Tim We have been having conversations as a precursor to going through the first layer that Raj describes, which includes moving the traditional middle office closer to the treasury team’s function. With this expanded scope, the collateral team can communicate with portfolio managers about what is most needed and receive instruction from managers about what to use.

Hugo To what extent are your portfolio managers engaged in this process?

Tim We’re not in scope of clearing yet. So with no increased margin calls to meet, the conversation is still theoretical. But portfolio managers are interested in the future scenarios we provided that explain how costs could be a drain on performance.

Mark I agree: until costs begin to bite into the bottom line, it’s sometimes hard to focus minds.

Guy Is anyone seeing interest from major institutional clients in aggregating all their collateral centrally by pulling it back from their investment managers so that they can control it themselves?

Raj On a recent trip to Australia, I found fund managers for the first time talking about doing this centrally. Outsource providers should be able to deliver here: because our product is custodian-agnostic, we can see the entire daily inventory of a client, instruct what has to be moved and send the instructions to the custodians.

Hugo How far could higher costs for trading OTC derivatives change the instruments that fund managers use?

Tim Some of our desks are already taking an active interest in OTC ERIS futures, although I would say it’s still a question of chicken and egg in terms of liquidity. It’s something that we expect to grow over time.

Mark Our LDI managers already use 10-year gilt futures as an alternative to swaps, and there are 30-year gilt futures coming out next year, which we will be active in. Managers consider which instruments to use on a case-by-case basis: as OTC clearing becomes mandatory, I think the extra expense associated with OTC contracts will see a shift to listed alternatives.

Guy It’s not always easy to get the same exposure through exchange-traded products: we had one client who tried to get out of cleared OTCs altogether but ultimately they had to retain some OTCs. We also had a buy-side client looking to set up their own aggregation fund to trade derivatives of a particular strategy that the other internals clients could just invest in to get their hedges. The idea was that if one manager within the firm wanted to manage a particular currency risk through, they could just invest in units of the currency-hedging fund rather than trade themselves directly.

Roger I think we may see demand for FX futures when FX forwards are pushed onto central clearing.

Hugo At what point would it become appealing for buy-side firms to post less eligible assets – corporate bonds and even equities – at CCPs, accepting punitively large haircuts, instead of using securities finance desks to provide more eligible assets, which can be posted with smaller haircuts?

Mark The decision to post less eligible assets and incur a larger haircut depends on your business needs at a given time. Obviously, a smaller haircut is preferable. Either way we need our collateral management team to be able to identify the options available and advise on the most appropriate course of action at that time. In general it’s worth noting that we’re keen for CCPs to keep acceptable collateral as tight as possible to limit the risk we face with them.

Tim I agree that it’s a concern that CCPs may widen the pool of eligible collateral to win business — some, for example, have suggested this route along with offering transformation and repo services. We’d certainly be wary of engaging with these extended offerings at this point in time. We will look at the portfolios on a case-by-case basis.

Roger Fishwick, Chief Risk Officer, Thomas Murray Data Services.

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Roger On this question of concentration risk, it’s worth noting that the risk profiles of the different CCPs differ considerably, as our risk analysis of the 26 major CCPs (such as LCH) has shown. I’m not sure that people are fully aware of the significant differences between them.

Hugo How well suited to outsourcing is the type of collateral management needed to meet the new margin requirements?

Tim Providing collateral management services will be an important business for outsource providers. Most will likely combine it with their existing custody service and the internal securities-lending businesses, placing optimisation on top of these existing services, as Raj has described. We have a mentality of outsourcing. So naturally we would look to these providers first for solutions: if they can offer a service, then it would certainly be of interest to us.

Conclusion

It is clear from the discussion that the regulations are making collateral management more complex for buy-side institutions. The likelihood that certain funds will face a collateral squeeze and require optimisation and transformation solutions continues to be one of the key themes under debate. The overall cost of adhering to the new regulations is the other topic that concerns most buy-side institutions. Will the cost simply make it uneconomical to collateralise the OTCs that a fund trades? Could this lead to a fund having to change its trading strategy?

Given these costs will ultimately have an impact on the value of the fund, portfolio managers should take heed. However, given the long, multi-year phasing-in of the regulations the impact is not biting immediately and so portfolio managers are currently remaining largely detached. The operations of many buy-side institutions are now fully engaged. And these entities are evaluating options that range from moving to exchange-traded derivatives to engaging in collateral optimization or transformation. Many view collateral management as an important but non-core function and are seeking solutions and services from outsourcing providers to benefit from industrial-strength and scaled solutions that integrate custody, lending, clearing and collateral management and so achieve greater efficiency in the selection, transformation, settlement and recall of collateral assets.

Part of this article was originally published in Global Investor, January 2014.

Roundtable underway as participants discuss how regulation will affect OTC derivatives and shape future buy-side collateral management.

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