The New Business of Collateral Management

Bank failures, record oil prices, asset fire sales. Reading the headlines lately, you would expect that financial markets are ready to freeze up and cease operating altogether. One would also expect that trading volumes would suffer mightily in the heightened risk environment of today, especially as market participants re-evaluate trading relationships with favored counterparties, credit lines are slashed and margins are reduced across the board. The collapse of many financial services firms, beginning with Bear Stearns in March, has been a wake-up call for others in the industry. And you can be sure that each and every buy- and sell-side firm has increased its vigilance of existing trading relationships, reevaluating all of its counterparty’s creditworthiness and reexamining the rationale of even the smallest trading relationships. There has been a renewed focus on improving risk management policies and procedures governing Treasury operations at sell-side firms responsible for financing trading activities through securities lending programs. Liquidity in today’s global markets is dependent on these financing activities through which securities firms finance trading operations by lending and borrowing securities to/from counterparties, customers, and competitors. Critical to the efficient operation of global capital markets, these activities allow sell-side firms to finance wide-spread trading activities by lending securities held in custody.

The same is true for the other side of the coin. Buy-side accounts are quickly realizing that efficient collateral management is not only prudent but also can provide a critical competitive advantage, especially given the credit environment of today and particularly so for hedge funds that depend on these financing arrangements to fund activities.

Hedge funds and their strategies have evolved dramatically in recent years with more complex investment parameters reaching across multiple asset types, geographical barriers and complex investment structures. As their activities have grown in complexity, hedge funds have turned to formalized systems for managing collateral requirements. Although this is partially a response to the increased complexity of their activities, it is also recognition that the benefits of efficiently managing collateral can provide a significant competitive advantage.

It is no longer feasible to manage this complexity through spreadsheets. As trading operations have become more complex, the process of managing financing activities has become increasingly complex as well. Managing balance sheet exposure to multiple counterparties in multiple jurisdictions and across multiple asset classes is a herculean effort that is increasingly viewed with renewed vigor. More and more attention—and resources—are being invested in the systems and processes to make these processes more efficient, while at the same time mitigating the risk associated with the lending and borrowing of the underlying collateral. At the same time, the heightened awareness of risk in today’s credit-conscious securities market has resulted in a re-evaluation of the effectiveness of the tools required to effectively manage these programs.

Executing a repo on a U.S. Treasury bill may be as easy as a few clicks of a mouse, but when transactions involve hard-to-value heterogeneous instruments, the process quickly becomes challenging. Securities lending practices of today include instruments far more sophisticated than plain vanilla stocks and bonds traded in an investor’s home market. Global securities denominated in different currencies, customized OTC agreements, derivatives and structured products are all commonplace and actively traded today.

The diversity and complexity of a hedge fund’s portfolio provide a number of challenges that hinder efficient collateral management, especially for portfolios focusing on lesser traded instruments. Valuation methodologies are coming under increased scrutiny as less liquid securities are more frequently employed as collateral. Adhering to disparate regulatory requirements associated with lending securities originated in different countries and legal jurisdictions is a monumental effort as well.

Accurate valuations are the foundation for being able to borrow or lend a security. The ability to accurately value an instrument used as collateral is simple when the security in question is a publicly traded stock. But valuing a customized OTC total return swap in real time is a more complex process. In today’s risk-averse environment it is no longer acceptable to rely on an “estimated” price for an instrument that is generated by the counterparty to the swap. Instead, firms need to have multiple pricing sources and must be able to defend and document the process and procedures used to evaluate the collateral.

Firms expect transparency in the valuation process used in collateral management programs and require the ability to explicitly audit the procedures and processes used in the evaluation process. Opaque processes that provide little detail are a thing of the past, especially as regulators expand their efforts to examine the inner workings of both sell-side and buy-side firms. It is essential to have the ability to review the inner mechanisms of a collateral management program, with real-time access to data and reporting systems a bare necessity.

Regulatory landmines abound as well. Regulatory regimes of all parties in a program need to be accommodated, not only those lending or borrowing the instrument but also the regimes where the security was issued, listed and traded. Rules governing margin vary by locale, and a firm offering cross-border collateralization services needs to have systems in place that can manage the intricacies of SEC, FSA or AMF regulations regarding margins, haircuts and collateralization protocols.

As firms have expanded their trading activities to span the globe, their financing demands have become correspondingly more diverse and meeting these regulations is critical in any financing operation. Running afoul of securities regulators is a sure way to decimate returns and the efficiencies of any financing operation, and today’s complex global regulatory environment presents a significant obstacle for any global operation.

More and more resources will continue to be devoted to the effort of efficiently managing collaterals, not only to handle the increased complexity of the underlying markets but also to make the processes more efficient and provide a competitive edge. The leading securities firms of tomorrow with global operations encompassing multiple asset classes are increasingly seeking to leverage their complex operations. The capability to efficiently manage financing activities to maximize returns not only provides another means to beat a competitor across the Street or on the other side of the world, but also serves to minimize overall risk. In today’s volatile environment, minimizing risk may ultimately decide tomorrow’s winners.