Is collateral optimization the next big thing?

It is safe to say that professionals working in securities finance, liquidity and related fields know that collateral management is a major priority for 2012, and a large portion of this work deals with managing margin calls from different CCPs. Equally important however is how collateral gets optimized internally at each bank, asset manager or insurance company. This is a question of aggregating all available positions and doing some fairly complicated math. We think that collateral optimization may be the next big thing.

Collateral optimization involves multiple variables, including understanding the portfolio marketing calculations of different counterparties, what assets are available to post and what the implicit or explicit costs are of those assets. Citigroup put out a good piece on these factors yesterday, noting the following characteristics as moving towards an efficient use of collateral:

– Utilizing securities as collateral
– A willingness to rehypothecate assets
– Looking closely at cash reinvestment strategies
– Considering variations on the collateral upgrade trade

We agree with all these points and will add another big one: getting the math right. This might be the trickiest part of the whole operation as it relies on a complex understanding of differing haircuts and changing market environments in order to price assets correctly. Collateral optimization is really a very complex pricing engine that relies less on market data and more on the rules and regulations of counterparties and agreements. Managing this process on a daily basis is not for the faint of heart.

While a few big banks have already built their own collateral optimization tools, we think that the future will be owned by firms like SunGard that allow multiple clients to outsource the cost and upkeep. It can be argued that collateral optimization is something of a commoditized service, albeit one that only a few players can ever really hope to get right. As such, it makes sense to consider outsourcing even if a firm has other parts of a collateral management service in place. For example, a poster of collateral may use SWIFT or AcadiaSoft for messaging but use SunGard’s collateral optimization tool to pick what goes where (although SunGard can sell the whole package as well of course). As firms like SunGard are increasingly powering the back offices of banks that themselves offer outsourcing services to clients, the vendor’s role takes on a broader importance for the industry as a whole.

In addition to the quantitative variables, some qualitative measures are also important, for example understanding what options are available if a fund is paying interest on cash or securities positions. These variables can be coded, but it takes a person to make sure that the terms are right to begin with.

Citi’s collateral optimization piece is here.

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