Pricing Collateral in Turbulent Markets
At the heart of the collateral management challenge is the valuing of collateral. "The biggest issue is valuation -- pricing of collateral," Citisoft's Migliore says. "When you're doing cash collateral, that's one thing. But when you're dealing with securities, it's much more difficult to assess the underlying value. That creates issues in terms of what you might value the collateral at and what your counterparty values the collateral at." Firms also need to accurately price the derivatives for which they are providing collateral to make sure they haven't provided too much, he adds.
Collateral valuation is especially critical to CDSs, adds Ed Grau, senior executive and head of risk and regulatory management in Accenture's financial services group. The reference credit on which a swap is based has traditionally been valued according to a rating or some other static measure. "We're seeing an increasing emphasis on those measurements, with companies looking at the equity price and the implied spread on any debt that's trading on the secondary market to determine the market-implied rating or probability of default for that credit," he says.
"If there is a credit default swap market for a particular credit, they're asking the CDS price," Grau adds. If the price is high, the market feels that there is a high probability that that underlying credit will default and trigger the need to cash in on the CDS that's acting as insurance, he explains.
Another key calculation, Grau says, is determining the creditworthiness of the underwriter of the credit contract. He notes that negative market sentiment about a CDS's underlying credit sets off a vicious cycle of gloom, making it hard to accurately price collateral.
"Here's the spiral: A company's credit gets downgraded, its cost of borrowing goes way up and various institutions ask for more collateral to hold its credits. The company then has to borrow, which makes it even weaker, and its credit drops considerably, as does its ability to repay, which fuels [a rise in] the credit default swap price," Grau says.
"It's a doom-and-gloom prediction that this company will default because the market's demand for credit default swaps runs the price up," he continues. "As the pendulum swings, it is difficult to find the center point, so it's very difficult to price the collateral."
To find the value of collateral, firms can pass components of the collateral to the front office to discover their price in the marketplace. "Instead of doing these calculations on centralized risk management platforms, companies are pushing that valuation to the front office to get a standardized view of the world," Grau says. "This makes sense. For instance, a person trading the FTSE index would be the best source to quote prices of the various components of that index."
But measuring collateral consistently across the enterprise presents another hurdle, Grau notes. "If I measure my collateral across the firm in 10 different ways, I don't have a clear picture of what collateral I hold," he says.
A companywide view of overall exposures to counterparties can be obtained manually by aggregating information from different desks and product areas of the firm. Technology, of course, could streamline the aggregation process. But this requires identifiers to be created for every counterparty and used across the enterprise.
However, enforcing a common pricing methodology enterprisewide, Grau says, is a challenge in and of itself. "There are as many ways of pricing these individual exposures as there are business divisions," he relates, suggesting that lending, trading and risk management groups will price instruments differently. "When you're assessing the overall credit risk, measuring credits uniformly provides your overall exposure calculation before you make a decision on your exposure."
Grau says one of the best practices he's seen in the marketplace is the creation of a centralized group focused on collateral management that identifies collateralized counterparty exposure across the firm. According to Grau, the group either takes it upon itself to find out a discovered price for collateral or it engages valuation services or front-office groups to determine prices for the collateral. The group also maintains contracts, taking care of any adjustments or modifications that have to be made based on circumstances.
Still, he notes, he has not seen firms make big technology investments in this area -- yet. "I'm seeing a lot of specification and requirement gathering. I'm seeing companies pull together information in general and try to interpret and convert that into a common way of pricing," he says.
Demand for Third-Party Safekeeping
An enterprisewide, global and accurate view of collateral, and of the terms and conditions of the collateral agreement, can help companies navigate the dangers of reassignment of derivative contracts. For instance, when Lehman announced its bankruptcy on Sept. 15, it was reported that many hedge funds didn't know the scope of their overall exposure to Lehman. But this was an oversimplification, according to one industry insider, who says that hedge funds were aware of their original positions with Lehman. Rather, many weren't aware that their positions with Lehman in the U.S. had been rehypothecated to Lehman's European entity, which unexpectedly had an administrative order placed on it by a U.K. regulator that froze Lehman's European accounts.
"There were a lot of questions and uncertainty around exactly what would happen in those first few days [after Lehman filed for bankruptcy] and what people's rights were under their agreements with Lehman Brothers," says Jim Malgieri, EVP and global product manager of global collateral management services at BNY Mellon. "It's those types of questions and concerns that raise the specter of collateralizing. The market and the way we all participate in it have changed dramatically, and the industry has transformed itself to the point where any time one counterparty has exposure to another, collateral agents or independent third parties will be hired to be the honest broker or cop to make sure each side is protected."
As a result, J. P. Morgan and BNY Mellon, the two largest providers of tri-party repo, are experiencing increased demand for their services. (Tri-party repo is an arrangement under which collateral is held at a third-party custodian rather than by the investor.)