Collateral Management: Outsource, Insource or Cloud. Which way to go?

An article in Institutional Investor dated February 10, 2014 “Outsourcing Collateral Management Can Be a Mixed Blessing,” by David Turner was interesting. It got us thinking….

The life of investment managers has gotten considerably more complex with the advent of centrally cleared derivatives. A high quality counterpart used to get away with low or no initial margin on bilateral trades, but those days are over. Each centrally cleared deal requires initial margin to be posted. Depending on how clever your FCM is, some exposures can be netted, while others aren’t. Cumulatively, the new collateral required across the system is a trillion or more. The art of managing those exposures is familiar to any repo trader: you are the traffic cop.

But not every financial institution can support what is, in reality, an internal repo desk. The technology investment necessary to bring together available collateral, figure out exposure and validate margin calls, optimize who gets what and then book the trades to settlement systems and GLs, to say nothing of getting the systems architecture to all play nicely, is no small matter. The expertise to play repo traffic cop isn’t always present within organizations. And regulatory timelines can be unforgiving.

Enter the custodians. Several custodians have rebranded themselves as purveyors of all things collateral. This makes a lot of sense since they already have the settlement plumbing in place with their clients, not to mention huge amounts of paper ready to lend out to cover any collateral need. Custodians are in a position to manage their clients existing collateral and send it off to FCMs as necessary. The real juice in the business is when the custodians need to do some sort of collateral transformation – for example, the client only has equities, but needs HQLA to post. As we have written in earlier posts, that part of the business is getting a slow start. Those posts can be read here, here and here (the first two are Finadium subscribers only.)

So with custodians offering an elegant plug and play solution, what is the flip side of the argument? Well, it is expensive. From the article:

“…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…”

Of course everybody has a dog in this fight; custodians and technology providers included.

So for a small asset manager, the fixed cost might be a problem. But the technology solutions available to bring the process in house are also not cheap. There are other options. Shops like CloudMargin, SL-X, and Quartet have web-based solutions that claim to be more economical. It still requires someone internal to manage the process as opposed to outsource and out of mind. Come to think of it, anyone who pitches the “just leave it to us” school of collateral management should be viewed skeptically.

For mid-sized managers, the decision is potentially harder. There is a point when asset managers get to critical mass. By this we mean that activity starts to absorb at least one, maybe two, full time jobs and errors can get really expensive. Those managers might go in either direction – custodian, insource, or outsourced technology (in all fairness, the major technology providers in the space can also host their service in the cloud, but at a cost).

Larger asset managers may opt to go with a custodian in the short run – one less regulatory headache to manage – but in the long run taking the process in house may be a better solution. For big players, collateral optimization isn’t just about figuring out which securities should go where. Collateral management is complicated and dynamic. It is a function that can easily go from being a pure cost to a profit center – and that means it ought to be front and center.

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