Why Risk Management Should Include Collateral Management
Collateral management is rapidly becoming an essential and integral part of a financial institution’s risk and regulatory compliance framework. Apart from evolving into a dedicated business practice, collateral management is gaining in importance as an effective risk mitigation technique in the areas of credit risk and market risk management.
At its core, collateral management is a credit enhancement technique that protects assets against a credit event associated with privately negotiated derivatives and other transactions. These events may bring forth credit risks such as a default by the counterparty. Collateral management can be used either for individual deals or for a portfolio of deals. In capital markets, collaterals are typically categorised under various financial instruments like cash, securities (government bonds), equities, commodities, FX, mutual funds, etc. A major difference between the capital market collateral assets compared with other common collateral assets is that the volatility of the underlying exposure varies on a daily or intra day basis.
Collateral management has increased in complexity and coverage in the past two decades to emerge as a major force in financial markets in terms of volume and operations, as seen in Figure 1.
The ideal collateral management system (CMS) should be able to handle all the following activities in an integrated fashion:
Collateral arrangement can be unilateral with just one party posting collateral or bilateral collateralisation with two-sided obligations, such as a swap or foreign exchange forward. Typical collateral agreement should specify the acceptable collateral, frequency of margin calls, haircuts, threshold level, close-out and termination clauses, valuation and rehypothecation. Rehypothecation is when the secured party may wish to make use of posted collateral, possibly lending it to another party or posting it as collateral for its own obligations to another party.
Allocation of collateral is a complex process in any CMS. Collateral allocation validates various high level parameters, like rating, maturity and currency, before allocating the collaterals for transaction. All allocation should be documented and monitored to avoid any dispute during reconciliation and margin calls.
In a typical CMS, the secured obligations are periodically marked-to-market and the collateral is adjusted to reflect changes in value. Margin calls will be issued as required and corrective actions taken immediately to minimise the risk of under-collateralisation or over-collateralisation depending on market fluctuations.
CMS should define processes to perform accurate calculation of collateral held, posted, utilised and requested, using related contract provisions including thresholds, independent amounts, and rounding amounts. Although MTM is the most common parameter used for collateral calculation, credit managers also evaluate other parameters like potential future exposure (PFE) and value-at-risk (VaR) as a means of calculating risk associated with collateral exposure.
CMS should be able to define processes to perform a detailed trade-to-trade position reconciliation of collaterals on a daily basis to ensure that all trades in the portfolio are subject to an executed collateral agreement with the counterparty. Reconciliation allows two parties to agree on the number, exposure of any existing trades and resolve disputes on margin calls.
The CMS should optimally allocate available collateral to any underlying obligation in a fully automated manner, enabling investment managers to make the most efficient use of global collateral inventory. Collateral diversification, cross-collateralisation, netting and cross-margining are essential tools for collateral optimisation.
An essential part of any CMS is the facilitation of counterparty communications by defining the method and type of communication. Accurate and timely communication combined with the right communication tool can reduce the number of disputes relating to margin calls, collateral exposure and collateral evaluation.
The ideal CMS should have extensive reporting capabilities for reporting on current collateral position, correct margin calls to the customers, shortfalls in collaterals and composition for collateral in case of multi-asset collaterals. For accurate collateral reporting, the solution should have timely external price feeds, reliable and accurate data feeds.
The CMS should provide various benefits in terms of increasing trading opportunities, lowering credit limits and reducing regulatory capital. Collateral management can integrate with order management systems (OMS), enhancing capabilities for margin trading by providing real-time value for exposure secured against collateral.
CMS should help financial institutions to comply with regulation and compliance standards in the areas of risk management, portfolio management and reporting requirements. Basel II recommendations for risk management are a core functionality of any good CMS.
As can be imagined, the process of creating a comprehensive collateral management solution is not without its challenges. Some of the key problems that will have to be overcome include the following:
Most CMS in their current state are dislocated, ‘silo-based’ systems with function delineated by location, business line and practice. Implementing a proactive, integrated system for the management of collateral assets will be one of the biggest challenges facing collateral managers in years to come. Successful execution of CMS requires diverse capabilities – operational, risk management, marketing, custody, settlement, legal, documentation, and client service skills with open and frequent communication with all partners within and outside the organisation.
Use of CMS reduces the credit risk associates with default of counterparty, but in the process it introduces additional risk that needs to be managed and mitigated, including:
Institutions use CMS as a risk-reducing tool but it generates undesired side effects in terms of market disturbances. Adjustment of collateral standards by a major player during stress periods will add to the market disturbances resulting in other players in the market rushing to correct errors. For example wide spread liquidation of collateral following defaults can generate severe strains for both holders and providers of collateral which will affect the price movement in the market in a significant way.
Another challenge in CMS is to represent the data in a format that is readily decodable by all market participants. The industry is moving towards FpML as a standard for this purpose. FpML will enable firms to deliver portfolio information electronically in a format that allows the file to be read by other systems, thus improving communication between counterparties.
Business requires continuous innovation and sophistication in CMS. An institution with an integrated and well-run CMS on new technology platform will hold a competitive edge over others.
Increased competition, shrinking profit margins and stringent regulation will increase the pressure on financial institutions to manage their collateral for optimum utilisation of their portfolios. Financial institutions will be investing more on day-to-day collateral management process using in-house or third party vendor solution to audit their contractual responsibilities and take a more active role in margin management, reporting and collateral use.
Explosive growth in the OTC derivates market will increase the needs for CMS to support market changes in product structures and new margin techniques. The solution should also be flexible enough to allow incorporation of new changes on the fly.
Many financial institutions have started reviewing their solutions for collateral management due to the increase in a range of market products and services and regulatory compliance requirements. A good collateral management solution should consist of co-ordinated organisational structures, processes, methodologies and IT instruments to achieve credit risk mitigation. Effective collateralisation allows managing a widening range of products and services offered, combining the accessibility to funds by the client with economic sustainability for both the client and the financial institution. Financial institutions are recognising the benefits of collateralisation and strategising to develop approach for developing effective CMS. The next major milestone in collateral management is the emergence of central clearing bank for collateral movements, which represents the fundamental improvement in market efficiency.