Technology Preparations for New Collateral Infrastructure

The emerging collateral environment places new requirements on banks, insurance companies and others to not only manage collateral internally, but also connect efficiently with external infrastructures. This is becoming a core question of business strategy as there are potentially meaningful cost consequences to these decisions. Finadium’s recent research report on tri-party repo and collateral agents looked at how those agents conduct their business; the reverse question is what best practices are necessary for market participants in collateralized transactions when interfacing with tri-party agents, CCPs and Central Securities Depositories.

There appears to be a general comfort with the tri-party mechanism in financial markets. In the US, an estimated 2/3rd of the repo market is done on tri-party according to the Federal Reserve, and custodians report sharp upticks in their client demand for segregated accounts for OTC derivatives collateral. In Europe, the most recent ICMA European Repo Council survey showed a 22% increase in tri-party volumes from June 2013 to December 2013. While bilateral and CCP options are evolving, the tri-party model appears here to stay as well. Further, the use of one tri-party manager is not necessarily a zero-sum game for others; multiple types of collateral management and collateral segregation means that multiple providers may be used across products and geographies.

The emergence of new types of collateral management strategies, including a greater use of cash and non-cash transactions, requires thinking through existing operational flows and technology. In an earlier article, we looked at the dynamics we expect will drive non-cash collateral. The use of tri-party optimizes non-cash collateral within the tri-party manager’s infrastructure. The next question is how individual firms optimize their own cash and non-cash collateral usage across multiple points of connectivity.

There are additional benefits to technology that looks at collateral both internally and externally. Connecting information on collateral and securities settlement lets firms know that newly settling securities will be available as collateral as soon as settlement finalizes. In a cash-rich, balance sheet neutral environment this information may have little impact. However, in a non-cash collateral, balance sheet-constrained environment, this is the type of information that produces genuine competitive advantages. Better real-time reporting about collateral holdings, allocation and intraday optimization opportunities create opportunities for market participants.

Collateral technology that assesses both internal and external positions has a newly emerging cost implication that few firms have yet considered: modeling risks and balance sheet costs yields new conclusions about the value of different financial transactions. As an example, a risk model of one dealer that shows a surfeit of available non-cash collateral may preference the cost of the next trade collateralized by cash. Conversely, another dealer may show better pricing for a non-cash collateral trade, depending on how collateral is moved and custodied.

Managing collateral both internally and externally is a complex equation that must be solved repeatedly during the trading day for optimal cost management. The challenge can be surmounted with technology, but requires first a careful consideration of strategy and operations for a successful result.

Thanks to Broadridge for sponsoring this article and moving the conversation forward.

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