Collateral Management - Buy, Build or Bounce
The last few years have seen something of a quiet revolution in the world of investment management as managers have begun, slowly at first but with rapid acceleration to get involved in the hitherto esoteric world of OTC derivatives. Increasing liberalisation in regulation of pooled vehicles as well as pressure on managers to deliver returns to ever more demanding and savvy clients have led to managers seeking to access the asymmetry of return which derivatives can provide. The front office has in many cases been in the box seat of this change. Quite naturally, resources tended to be concentrated on providing systems and controls to enable the investment professionals to make decisions and monitor OTC positions. The flip side of this approach has often been that volumes have in many cases been limited due to the constraints required to ensure control over new operational processes necessary to support OTC trading.
With the advent of the chill winds of the credit crunch, the fallout from the collapse of Wall Street giants Bear Stearns and pressure on Fannie Mae and Freddie Mac, Asset Managers have placed a renewed emphasis on the operational side with a focus on credit risk mitigation. As managers increase their trading in OTC’s, many of which are long term commitments, they tie themselves into credit relationships with the organisations at the eye of the storm to a far greater extent than ever before. Arguably we have reached the paradoxical position of the investment managers having to worry more about counterparties' credit risk than vice versa. As the situation has developed, there has been a growing realisation of the value of a well defined, robust and scalable collateral management process as part of the credit risk mitigation strategy. In many cases, the collateral management function among the investment management community is far less well developed than on the sellside and for very good reason. They have had 20 years or more to perfect the operating model. They have developed or bought systems that remove volume constraints, so important when relying on high-volume low-margin trading and they have organised themselves operationally in such a way that they have in-house talent pools with depth of understanding of the products and processes required to provide controlled environments around their trading, systems and processes.
Impact on the Operating Model
So how can Investment Managers build up there collateral management function so as rapidly to provide the support for higher volume OTC trading while ensuring that control and process counterbalance increased operational and credit risk? Firstly they can look to their ISDA agreements and particularly the economic terms of the agreements enshrined within the CSA’s. In the initial phase of agreements, both managers and their counterparties tended to be happy to engage in contracts in which the resultant collateral management activity was limited. Hence thresholds and MTA’s tended to be high and the frequency of calls tended to be low. Quite simply, the complexity of managing multi-client, multi-portfolio collateral agreements placed limitations on the effectiveness of the credit risk mitigation undertaken by the organisation. Increasingly, best market practice is beginning to converge on the end of the spectrum at which thresholds and MTAS’s are reduced to the lowest level possible – zero. At the same time, Managers are increasingly coming to the realisation that, as markets and sentiment continue to be volatile, the periodicity with which collateral positions are calculated and mitigated ought to be aligned more closely. Again, best market practice is tending towards the paragon of prudence – daily collateral calculation. At the same time, as OTC trading volumes increase, the tendency to limit eligible collateral to cash begins to become less attractive. Many fund managers have a ready pool of bonds which can be used to provide collateral instead of cash which may not always be available to cover collateral calls. Further, being delivered cash can present the thorny issue of the manager having to achieve a benchmark interest rate. In the case where this is not achieved there is a direct cost to the fund over and above the operational cost of monitoring and reporting on cash returns. As a result, best practice is moving towards the area of bilateral cash and bond collateral. Of course, these changes do come with a price. Reduction of thresholds and increased frequency of calculation is likely to lead to greater incidence of collateral movements. Use of bond collateral requires a means of tracking collateral and facilitating recall where trading activity or coupon payments require. This puts pressure on the people, systems and processes underpinning the collateral management function. Ensuring that all this is managed on a potential multi-client, portfolio and currency basis to a daily deadline while maintaining a picture of existing collateral which may be either delivered or in-transit is clearly a non-trivial task. Add to this the communications chains between the relevant stakeholders including front office, counterparty, custodian and Internal management and the complexity represents a considerable operational challenge. At this point, we need to consider the options available to the investment manager.
As I have already mentioned, the Investment Banks have had a significant head start with regard to the OTC derivatives operating model. Having already suffered much of the pain now being encountered by the buyside, many have opted to support their collateral management programme through the implementation of vendor software. This has over time been developed to provide the complete solution to all collateral management needs and ensures robustness, scalability and control. However, as with any implementation, the appositeness of vendor CM software for investment managers does need to be considered carefully. This software is designed to be able to support the requirements of high-volume, high frequency collateral programmes and as such is industrial strength in the functionality and flexibility of workflow it offers. One corollary of this is that it can take time and hence money to implement. For the small fund manager or manager with simple fund and ISDA structures, this solution may represent a sledgehammer to crack a nut. For the larger organisations with greater complexity, the cost benefits case may revolve around potential savings over time from a reduction in collateral management resourcing requirement brought about by the implementation. Given that OTC derivatives are here to stay in the IM world, this may well be a solution for those managers who will be looking to maximise OTC trading volumes and want to maintain local control over their operational and credit risk.
Typically IM organisations engaged in OTC derivative trading in an ordered, step by step approach, limiting the volumes to what were considered by front offices to be fairly Draconian levels. This facilitated a considered and controlled approach to building up internal competencies required to manage the new risks from an operational perspective. Typically, the collateral management approach was MS Excel based with support from investment accounting systems around reporting. Needless to say, manual input was also very much to the fore as indeed it was throughout the rest of the OTC operational model. This configuration does tend to create issues as managers look to move to the next level of complexity. Increasing the numbers of ISDA’s, lowering thresholds, increasing calculation frequency and widening collateral eligibility require development of the spreadsheet based solution to some- thing approaching the level of functionality provided by the system vendors. At this point, the manager may well decide that MS Excel, as versatile and resilient as it is, is not the ideal platform on which to base a key component of the organisation’s credit risk mitigation strategy. As a result development may be required on an alternative platform. While the nature of the development required is relatively straightforward and can be managed through design of a rules based system, the impact on cost, time and resources cannot be dismissed lightly. At the same time, the requirement for a collateral team to manage aspects of the process such as substitution and management reporting is unlikely to disappear. Further, as the business continues to develop and evolve, there is a very real danger of the road to hell being paved with good intentions as the system and process need to be maintained. The bespoke nature of the homebuilt collateral management system requires that the documentation and practical knowledge of how they are built needs to be kept up to date and available. Key man dependencies on the development side present a real risk and will require management time. The homebuilt solution is certainly a highly practical one for many organisations and there is no reason per se why it should not continue to be used. The questions really are around the breaking point of the system in terms of its ability to provide adequate credit and operational risk control.
The trend for outsourcing of non-core functions continues to have its proponents and detractors. Recently the outsource providers have begun to latch onto the fact that they have sufficient scale and scope to be able to perform the service for the buy-side at a price which makes them competitive with both the buy and build options. Several of the providers have extended to the buy-side the service they already offer to sell-siders and large corporate and they are beginning to gain purchase in the market. This provides several considerable advantages. Firstly, the manager gains access to market leading software providing the organisation with the means swiftly to move towards best practice in terms of thresholds and calculation frequency and providing all-round robustness and scalability to the collateral management process. Secondly, many of the outsourcers provide access to AAA rated cash investment vehicles which mitigate the risk of not achieving the required reinvestment rate on cash collateral balances deposited. Thirdly, the systems will facilitate the extension of eligible collateral beyond cash. As a result the outsourcers will perform collateral substitutions, removing a considerable headache from the investment manager. At the same time, the functionality exists (and is widely used on the sell-side and at the more advanced investment managers) for rehypothecation which can add valuable basis points to the funds re- turns. Further, the outsourcers will provide a suite of re- ports to take care of operational and MIS requirements to ensure transparency of service on a daily basis. Moreover, due to the level of collateral management skills built up within the outsourcers and the relatively straightforward client take-on process, the post-contractual implementation timescale can be reduced quite drastically.
It would appear that this solution combines many of the benefits of both buy and build with few of the disadvantages. However, clearly this panoply of benefits is not without cost. On the financial side there will still be costs involved in the implementation. The other cost is that inherent in any outsourcing– loss of ownership of the function. At a time of increased concern around credit risk, it may well be that a focus on collateral management operations provides considerable “bangs-for-buck”.