Previously, in part one of our three-part series on collateral management, we discussed the causes and impact of the increasing demand for high-quality collateral. The resultant demand-supply imbalance can turn acute in an unstable market, spiking the cost of high-quality collateral and disproportionately affecting market players. As a way to prepare for the inevitable and enhance your prospects, this instalment outlines a robust collateral optimization infrastructure.
The Case for Collateral Optimization
Consider total return swaps (TRS), a credit derivative used for off-balance-sheet transactions by asset managers and banks. Simply put, TRS is a bilateral contract to exchange the return on one or more underlying assets. "Total return receiver" (typically a hedge fund) must pay a funding cost (floating rate plus swap spread) to "total return payer" (typically a bank or dealer) in exchange for the total return on an asset. Most often, total return payer (or the "funding bank") requires an upfront posting of collateral by the total return receiver (or "swap counterparty").
If a hedge fund has to choose among cash, treasury securities or corporate bonds to post collateral, then its total economic return depends on the income generated by the underlying asset and its capital appreciation minus the cost of collateral and the opportunity cost of deploying a particular asset for collateral.
Total Economic Return = Income + Capital Appreciation - Cost of Collateral - Opportunity Cost of Collateral
To optimize collateral usage and make smart asset selections, the receiver needs to have a consolidated view of the asset book with its range of quality of assets. As high-quality collateral greases the wheels of financial markets and demand raises costs, it is prudent to invest in the necessary capabilities to optimize collateral usage.
Establishing An Optimization Roadmap
We suggest a three-pronged approach to launch an efficient, effective collateral optimization program:
First, create a central collateral management agency—a provision to drive collateral optimization by eliminating organizational silos, multiple operational structures with disparate IT systems and infrastructure that can have conflicting objectives. By adopting an enterprise-wide view, firms can improve their collateral usage efficiency by 7% to 10%.
Second, before embarking on an ambitious and expensive transformation program to address the collateral shortfall, firms must optimize their collateral portfolios with smart analytical tools and adopt effective optimization operating discipline. This is a difficult road but a cost-efficient one. The collateral optimization exercise is a complex program that takes into account the following provisions, which can add another 5% – 7% to the overall efficiency of collateral usage:
- Contractual agreements that specify the collateral eligibility criteria agreed on by the participants, including contract details and a subset of preferences within the contract.
- Available inventory and trades and/or liabilities to collateralize—position data, trade data, reference data, static data, pricing and rating.
- Constraint variables in the form of concentration limits across securities and currencies and asset allocation preferences—currency, security type, security volume, define at trade level, define at portfolio level.
- Additional influencing parameters for optimization are margins, haircuts, ATVs based on different time frames, market capitalization, regular business events and corporate actions, release requests and substitutions.
Third, after implementing a comprehensive optimization of available collateral inventory against obligations, firms must address the collateral shortfall through time-tested strategies such as upgrade trades, securities lending, margin financing and secured credit. This must be the last recourse to plug the gaps in the portfolio, since it entails costs that will be priced by the collateral demand at that point in time
Looking Forward: Smoothing the Path to Optimization
Firms focused on gaining sustainable competitive advantage must create a central collateral management agency with an enterprise-wide mandate to optimize collateral usage. This agency will underpin all optimization efforts and deliver a sense of purpose and direction to the firm's objective. Once the enabling infrastructure is in place, firms must focus on optimizing the collateral portfolio in a cost-efficient way, then, as the last step, rely on portfolio transformation techniques to augment the need for high-quality collateral.
For further in-depth understanding of the rigidities that impede collateral optimization, challenges organizations face and ways to overcome these challenges with our collateral optimization roadmap, please read our paper A Systematic Approach to Optimizing Collateral (PDF). Do not miss the concluding part of our series on collateral management Margins Take Center Stage. Visit Cognizant's Capital Markets Practice for more.