Collateral Optimization

A Fund Managers Perspective

Amid the continuing uncertainty over the impact of the forthcoming derivatives regulations in Europe and the U.S., there is marketwide consensus on one outcome: The amount of collateral posted will likely increase significantly.

This single aspect of the regulations will create major challenges for many buy-side participants in the areas of liquidity management, operational risk, trading strategy and, ultimately, investment performance. This OpenCollateralSM News article explores these effects and examines some of the options available to investment managers to use collateral most efficiently.

timings for the introduction of mandatory central clearing for specific derivative types. However, the overall thrust remains clear: Investors should expect sharp increases in the levels of collateral they will need to manage in the future.

Measuring the Impact of Inefficient Collateral Usage

The need for increasing amounts of collateral to be held or posted creates additional demands on portfolio managers and middle-office teams that, if not appropriately addressed, can result in significant additional costs for the fund. For example, some asset managers, for reasons of operational simplicity, restrict their collateral agreements to cash only. Increasing the size of this liquidity buffer necessarily results in a potentially larger tracking error with respect to the target index. A further cost associated with the use of cash collateral is the monthly interest payment due to the counterparty on any cash collateral held. Interest rates are fixed in the Credit Support Annex (CSA), typically at the Fed Funds Effective or the Euro Overnight Index Average (EONIA) rate. But funds will earn a return far below this lower rate from their custodians, resulting in shortfalls at the end of the month with costs that accrue directly to the funds. The use of securities as collateral is one solution for many funds, particularly those with holdings of government bonds that are still widely acceptable as collateral under CSAs. However, the step up in complexity that this entails can pose challenges for some operational teams, and the risk of additional costs, such as tax withheld on coupons, may undermine the perceived advantages in some cases.

Greater Need for Collateral Efficiency

Recent industry papers have estimated the additional collateral burden demanded by the Dodd-Frank and European Market Infrastructure Regulation (EMIR) legislation to be over $2 trillion globally.1 A major component of this increase results from the progressive move to central clearing of OTC derivatives and the corresponding requirement for all market participants to post initial margin to the central counterparties (CCPs) as part of the protection required by the CCPs against broker default. In addition to this requirement, a more immediate demand for additional collateral will arise from the regulatory requirement for financial institutions to collateralize all their OTC positions. While collateralizing mark-to-market exposure on open derivatives positions is common practice for many global fund managers, it is by no means a universal process. In some European jurisdictions, for example, it is common for funds to trade swaps without any collateral agreements in place, while some asset managers typically exclude short-dated instruments, such as foreign exchange (FX) forwards, from their collateral agreements. A further regulatory change that would increase the demand for collateral is the possible imposition of mandatory Independent Amounts (or initial margin) on all bilateral OTC contracts, in contrast with current market practice where the use of Independent Amounts is uncommon among long-only fund managers. The above regulations are still subject to detailed rule-making on both sides of the Atlantic, including the

Steps to Collateral Efficiency

For many funds, the optimization of collateral is simply a case of making best use of assets available within the funds inventory. However, there are a number of additional steps that funds can follow to minimize the yield drag of collateral: Securities as collateral: Enabling the use of securities as collateral can deliver the biggest single increase in collateral efficiency for many funds. Not only can funds use their own holdings to meet margin calls,

Investance

02 Collateral Optimization

they can also avoid the interest costs on receiving cash. The key requirement to support this procedure is a robust and versatile collateral management system that includes automated daily valuations of all collateral positions incorporating eligibility checking, credit rating review and haircut calculations for every CSA under management.

Investors naturally need to satisfy themselves as to the market risk they are facing and to ensure that any reinvestment vehicles selected conform to their investment guidelines. Subject to these constraints, cash sweeps can deliver significant improvements on collateral holding costs. Collateral upgrade: An idea much discussed in recent

Asset selection also forms a crucial part of this capability the function of identifying which assets are available for use as collateral (by earmarking or moving to a separate account) and ensuring that the current, prioritized list of eligible assets is available at the time of any margin call. Finally, systems for tracking forthcoming coupons and redemptions and triggering the necessary substitutions are also essential, along with a clear protocol for the rapid liquidation of counterparty assets in the event of default. Rehypothecation: Permitting the reuse of securities rehypothecation can further enhance collateral efficiency by minimizing the demand on the funds own inventory. In this context, rehypothecation refers to collateral received from one counterparty (i.e., in-the-money positions) being used to meet a collateral obligation to another counterparty (i.e., out-of-the-money positions) of the same fund. Naturally, rehypothecation requires effective systems to track all collateral inflows and outflows, so that the train of movements can be easily reversed in the event of a recall from the original provider of the collateral. Funds also need to give consideration to the risks they face under their ISDA agreements if they fail to return counterparty collateral within the agreed time lines. Cash reinvestment: The interest shortfall on cash collateral held can be mitigated or wholly eliminated by the reinvestment of cash received into appropriate short-term instruments to the extent that re-investment of cash collateral is permissible. The use of automated daily cash sweeps help ensure that the maximum amount of cash is reinvested and can be configured to meet any liquidity constraints.

months has been transforming ineligible assets, such as corporate bonds or equities, into widely accepted collateral. However, many of these solutions are based on secured lending lines from counterparty banks and are thus subject to the usual constraints of this type of transaction, including eligibility, cost, availability of balance sheet and commitment in times of market stress. An alternative approach, which may be a good fit for larger funds with high-quality assets, is a three-month evergreen lending transaction in which the fund lends a portfolio of assets in return for cash and pays a spread to the borrower. This arrangement is typically brokered by a securities lending agent and has the benefit of providing a degree of funding commitment, without the need to liquidate any underlying positions.

Legal and Operational Implications

Foremost among the legal considerations are the terms of the CSA relating to eligible collateral and rehypothecation rights. A careful review of these will reveal any immediate opportunities for funds to manage their collateral more flexibly. Even if these stipulations are currently restrictive, opportunities to amend them may arise when CSAs are renegotiated to comply with the more rigorous margining requirements arising from the new derivatives regulations. From an operational standpoint, the picture is of increased complexity and margin call volume, at least in the short term. Tighter CSA terms, a wider range of collateral types and greater pressure to use collateral more efficiently will dramatically increase the demands on the collateral operations functions, where careful planning is required now to ensure that the necessary functionality and capacity can be delivered before the regulations take effect.

Collateral Optimization 03

The planning task is further complicated by the longer-term impact of central clearing on bilateral trades. As many OTC derivatives move to CCPs, investors will find that some of their existing ISDAs will become redundant, so overall capacity demands will diminish after the initial spike. Uncertainty over the timing of introduction of central clearing for different instrument types makes it hard for many investors to forecast how quickly these effects will occur, which in turn makes it difficult to justify significant capital investment in new systems and operations. For these reasons, many investors are now considering an outsourced approach to collateral management to provide the capacity and capability they need, but on a variable cost basis.

For additional information: Americas: Daniel Ulrich dan.ulrich@citi.com Europe, Middle East and Africa: Fergus Pery fergus.pery@citi.com Asia Pacific: Pierre Mengal pierre.mengal@citi.com

Conclusion
New derivatives regulations in Europe and the U.S. will likely have a significant impact on collateral management for many investors leading to an increased focus on the efficiency with which collateral is used and managed. A number of practical steps are available to many buy-side entities to improve their collateral efficiency, provided they have the operational know-how and capacity to support more complex collateral arrangements. Given the continued uncertainty over the timing of the start of central clearing and of its consequent impact on bilateral relationships, many institutions are delaying decisions on new systems and processes. However, those that implement flexible and scalable solutions soon could be best placed to manage collateral efficiently and reduce performance drag on their funds. Fergus Pery Global Head of OpenCollateralSM Global Transaction Services, Citi

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