What is the Supply & Demand of Collateral?

The evolution of collateral management from a legal and operational process, has required financial institutions, mainly banks, to raise their awareness of the need for an Integrated Collateral Management (ICM). The areas that are involved in the process of designing and implementing an ICM process are essentially: IT Infrastructure, Risk Management Analytics, and Organisation. In Figure 1 we summarize the main problems for each of the areas. The technological infrastructure must be able to directly connect to the CCPs (or to Clearing Brokers in case of indirect clearing), and, possibly, with any counterparties with which the bank has a CSA agreement. The above is the minimal structure necessary to automate:

• margin calls (mainly of cleared transactions) on a daily basis;

• reconcile changes in value of collateralised contracts;

• pledge, receive and segregate collateral;

Obviously the integration of the ICM with other existing internal systems that will deliver relevant information is required to work seamlessly. In particular, the creation of central repositories of collateralisation agreements (i.e.: the contractual terms defining how collateral must be exchanged) and of the corresponding the directories of eligible assets, are essential for achieving ICM. Closely related to the technology aspect is the methodological one: the value change of collateralised transactions and the consequent reconciliation and exchange of collateral are possible only relying onto precise and validated valuation models. Furthermore, new metrics must take into account the collateral value. In fact, in addition to Counterparty Credit Value Adjustment (CVA), which measures the expected losses originated by the credit risk of the counterparty (accounting for the risk mitigation by the collateral), other measures such as the Liquidity Value Adjustment (LVA), which takes account of the difference in performance between the collateral and a risk-free security and the Fund- ing Value Adjustment (FVA), which incorporates the cost of funding, inclusive of the collateral cost, will be the new metrics to consider when valuing primary and derivative contracts and manage their risk.4 Conversely, whenever the collateral is represented by securities, a bank must have models that value such security, also simulating its future value inclusive of the haircuts.5 Both aspects, within the ICM paradigm, should be integrated in order to forecast (as an expected, or stressed, value) the need for collateral, thus allowing the design of strategies for locating it.

It implies therefore the creation of tools for margin simulations (initial and variation) for cleared and bilateral transactions. The ultimate goal is to optimise collateralisation, subject to the constraints applied by the main variables involved (funding cost, haircut, asset volatility, evolution of supply and demand for collateral, etc.). The ability to use a wide range of assets to manage liquidity and to cover margin calls on derivatives, originates from the margining requirements for both, transactions cleared through a CCP and bilateral transactions, in addition to the capital charges imposed by the Basel III regulatory framework. Collateral held towards OTC derivatives transactions is very likely to increase in near future. In this scenario, there will be a significant reduction in the availability of ”eligible” securities in the face of a significant increase in the cost of raising them. Collateral transformation6 will become then a key strategy for banks.

In fact, Market Makers and Institutional Clients will be required to hold a significant buffer of collateral to meet margining demands, both as initial margin (IM) and as variation margin (VM). There follows that also collateral optimisation will become a significant strategic activity. As the cost of the collateral will increase, collateral management and its optimisation will be the guiding criterion for efficiency. Those banks that can efficiently manage cleared and bilateral margining will enjoy a significant competitive advantage. On top of this shakeup of the technology infrastructure and methodology policies, there must be a full revision of the bank organisation. In other words, another integration must take place within the departments involved in the collateral management: Treasury Department, Risk Control, Legal and Back Office.

It seems straightforward to think that, in the design of a new organisational model identifying responsibilities, the pledging activity should be the responsibility of the Front Office. We outline here two possibilities, although not necessarily alternative and non- exhaustive:

• Responsibility assigned to the existing Treasury or Repo Desk, in both cases by extending the job description by virtue of the new ICM;

• Creation of a Collateral Management Desk, with a job description defined in the ICM, and with a strong emphasis on collateral management skills. The first option plays on the efficiency of such choice as it simply extend activities already carried out by the departments and the ability to leverage on the clear interdepen- dence of ICM with liquidity and funding management and Repo transactions. However, despite these advantages, the second solution allows for the creation of a department that has a precise focus on collateral management and the necessary skills in order to achieve an effective collateral management optimisation. In any case, it will be a desk with strong ties to the Treasury and Repo Desk. Actually, if we mean with Treasury the desk that manages the liquidity and the funding of the bank, then we strongly support the set-up of a new macro-desk, the Treasury, which includes the Repo, Collateral Management and Funding Desks: we will dwell more on this in the last part of this paper. The Back Office will be certainly affected by the change due to an increase in the num- ber of collateral exchanges and the Legal Department will be likely required to advise on a growing number of disputes in valuations and assessments. Risk Control/Management, to a different degree, will have to monitor credit exposures, the valuation of the collateral mitigating the credit risk, the cost of funding and in general costs related to locating and segregating the collateral. Also, aspects related to the liquidity of the bank will be measured and controlled in the context of collateralisation.

Finally, a dramatic increase of transactions will translate into higher operational risks (and consequent monitoring). Last, but not least, banks should design a system of internal transfer pricing for col- lateral, to supplement existing systems, allowing for a proper allocation of costs among the relevant departments. FVA and the LVA should constitute the essential tools for the design of such a system of internal transfer pricing.

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