Should we stop talking about collateral optimization now in favor of something bigger? (Premium Content)

We’ve had several discussions over the last two weeks about collateral optimization and its role in the market. One result of these conversations is that maybe collateral optimization is largely achievable and is now a poor end-goal for financial institutions, and that something bigger is now on the horizon. In this post we present our view of how a new focus on collateral could change markets for the better.

Here’s the punchline: collateral optimization is internally focused, helping firms make the most of their posted and non-posted collateral. Collateral optimization relies on knowing what a counterparty will accept based on a digitized collateral schedule and having a robust view of internal assets. These challenges are being met and will be further successful as more advanced collateral services and technologies come on line in 2016. The next step is a merger of collateral optimization, Collateral Transfer Pricing (which we will use interchangeably with CTP or Fund Transfer Pricing) and yield enhancement strategies. This requires not just knowing what is happening internally but combining that with market intelligence and the dynamic, rules-based requirements of counterparties. Its a triangle of information that will produce the most optimal results for collateral holders (which, between securities lending, repo, OTC derivatives and futures, is pretty much everyone).

This is a big goal, and one that relies on a vision of how things could be in an efficient industry. While a skeptic might say that this is an admirable but not achievable goal, we will beg to differ. We see the following points that suggest not only is this doable but that the process is already underway:

1) Collateral optimization and Collateral Transfer Pricing are two sides of the same coin. If you’ve done all the work to optimize collateral directed towards external counterparties, then pricing that collateral for internal cost distribution is pretty straight-forward. This is really taking all the pieces of collateral optimization (data aggregation, understanding counterparty haircuts, understanding the internal value of collateral) and developing a pricing engine for each internal provision or taking of liquidity. It is work of course to get to CTP, but it isn’t crazy-level work.

2) Knowing what you have is easy; knowing what someone else is doing dynamically is more challenging. The market is coming to understand the need for a 360 degree view of credit and collateral requirements. This takes the need for understanding an internal portfolio as a given, but also presumes that you cannot be effective in your counterparty relations unless you know what they need to. Collateral schedules are a great start, but markets, volatilities and liquidity can change suddenly. If you know that the market is doing something and that’s going to change your haircut requirement, you can adjust your collateral strategy to that reality. It is entirely possible that a market utility (maybe blockchain-based, or big data-based, or both) could emerge to offer a sort of model-sharing for collateral counterparties. The utility does not have to disclose any secret sauce but could return calculations based on external market conditions.

3) If the objective is yield enhancement, then that should be the name of the strategy. Collateral optimization is a great idea and can be found across a variety of methodologies, from ordered lists to multivariable database-driven calculations. But the point of collateral optimization is to earn greater returns, and that’s where sometimes we see firms drop the ball. Once you have posted the least cost collateral to your counterparty, what is there to do next? There are action steps that can sometimes be missing to move to the next level of collateral activity; we think these need a focus that is equal to or greater than the emphasis of the last few years on collateral optimization. An awful lot could happen with those securities that are left lying around but it takes a strategy to make anything work. There are already advisory firms that focus on this area but we find that many buyers aren’t that tuned in. Taking the perspective that yield enhancement, and not collateral optimization, is the ultimate goal would drive more focus to this area.

The collateral markets are already experimenting with new ways of doing business. Our favorite is still “agency prime brokerage,” where a prime broker conducts all the same services it does now but without the credit intermediation that brings balance sheet hits along with it. We will posit that collateral users can now aim higher in their goals; a financial industry model based on greater knowledge of what is happening inside the firm, at counterparties and in the market would bring market participants much closer to the goal of greater returns and would likely produce substantial operational efficiencies along the way. We think this is one of the next big topics of conversation in collateral.

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