The collapse of Bear Stearns and Lehman Brothers and the struggles of AIG have brought a gravity and urgency to counterparty risk and its sidekick, collateral management. Just as people tend not to think about insurance until they have an accident, collateral management -- the tracking and managing of the collateral that backs loans and credit-related derivatives -- was a relatively ho-hum middle-office function until the subprime crisis.
But as credit-related instruments become riskier, the underlying collateral becomes more important. And, "If you've got collateral out there and all of a sudden the collateral itself becomes questionable -- the liquidity of it or the pricing of it -- you could be asked to substitute [other] collateral or put up significantly higher amounts of collateral," points out Paul Migliore, CEO of consultancy Citisoft.
A collateral damage case in point is AIG, a major seller of credit default swaps (derivative contracts that act as insurance against risk that a credit instrument, such as a mortgage-backed security, will default). Many of AIG's CDSs served as insurance against collateralized debt obligations (CDOs), contracts based on complex packages of debt that can include subprime mortgages. Buyers of these CDSs have the right to demand collateral from AIG if the securities being insured by the swaps decline in value or if AIG's own corporate-debt rating is lowered. According to The Wall Street Journal, AIG has been hammered with collateral calls: In August and October 2007, Goldman Sachs asked the insurer to post a total of $4.5 billion in collateral on CDSs; AIG posted less than $2 billion. In November and December of that year five more trading partners requested collateral from AIG. In August 2008, as AIG's share price was plummeting, it had to post $16.5 billion in total collateral on swaps. The following month, AIG's credit ratings were cut, and on Sept. 16 the Treasury Department bailed out AIG with an $85 billion loan.
Since the credit crisis came to a full boil, investment firms have become much more attuned to counterparty risk, especially big players in the CDS market, which has a notional value of $60 trillion, according to Migliore. "A big challenge is that firms have taken collateral for granted instead of actively managing it," he says.
Although one might expect buy-side firms to manage collateral on a regular basis, "Firms were doing it weekly or, more likely, monthly, or whenever a broker-dealer made a margin call," Migliore continues. Now, however, firms are looking to value derivatives and collateral for their portfolios on a daily basis, he adds.
Some buy-side firms are investing in collateral management software that keeps track of collateral agreement terms and conditions, and maintains an audit trail of collateral movements. And custodian banks, including J. P. Morgan and BNY Mellon, which manage collateral as a service for others, report that their customers are asking for real-time views of exposures and collateral, so the firms are beefing up their technology platforms to answer this demand. "Being able to operate in a real-time environment so that [the borrower and the lender] can assess at any point in time that counterparty exposure and the underlying securities and transactions that define that counterparty exposure is a fundamental theme in the marketplace right now," says Kelly Mathieson, managing director, global clearance and collateral management executive, treasury and securities services, J. P. Morgan.
Meanwhile, the overall scope of collateral for derivatives contracts has grown. "The number of credit support annex collateral agreements that parties have executed with one another has grown, according to ISDA, more than 100 percent over the last few years," relates Tim Lind, managing director of strategic planning at Omgeo. "The value of collateral in the marketplace to offset derivatives exposure exceeds $2 trillion."
Heightening buy-side firms' collateral concerns is the fact that they've become more highly leveraged. "We've seen a dramatic shift in the way buy-side firms manage money," says Lind. "That dramatic shift comes with the use of derivatives -- both exchange-traded and over-the-counter -- securities lending programs and other types of transactions that create leverage, ... which in turn creates long-term counterparty and credit exposure. The risk of that leverage is constantly mitigated through pledging and accepting collateral."
For broker-dealers such as Credit Suisse, Goldman Sachs and Citigroup, the cumbersome, manual process of collateral and margin calls -- an uneven mix of e-mails, phone calls and faxes -- adds to the collateral management challenge. As such, 15 large broker-dealers are working to automate pieces of the collateral management process and plan to roll out an automated messaging system for margin calls in the first quarter of 2009 (see related sidebar).
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.)
J. P. Morgan Builds Global Collateral Platform
The largest collateral management service provider in the U.S., J. P. Morgan has seen its collateral management business grow 40 percent over the past several years, according to the firm's Mathieson, who reports that the company began a three-year, multimillion-dollar initiative in July 2007 to build a new technology and operating environment for collateral management to serve its clients as well as internal investment bank and asset management divisions across the Chinese wall.
"Up until the summer of 2007, collateral management, particularly tri-party collateral management, was considered a convenient service to outsource," Mathieson explains. "Organizations knew they needed to hold collateral against lending or trading positions; it was an appropriate risk management activity, but one that could be outsourced to third-party providers that could do it more economically. ... In the summer of 2007 the notion arose -- and it resurfaced in September 2008 -- that collateral management is a risk management tool and function that's core to any decision to lend or to trade. It's gone from a 'nice to have' to an absolute requirement."
Mathieson says she has pursued three primary goals for the collateral management project. The first has been to create a near-real-time view of collateral management for clients. The second, according to Mathieson, is to make collateral management information available globally so that clients can meet liquidity needs around the world and not be limited to using funding or lending facilities in separate time zones. And the third goal is to enable clients to have a virtual global long box that can operate in different jurisdictions with multiple legal entities in multiple time zones to help them lend or source financing from across their legal entities.
So far, the firm has been building basic infrastructure for collateral management activities. As J. P. Morgan's collateral management business has grown rapidly, disparate platforms have been developed in different parts of the world, Mathieson explains. As a result, she says, her group is working to sew these platforms together, with common data infrastructure, risk controls, reporting tools, definitions and client interfaces. Mathieson adds that she hopes this foundation will be completed by the end of the year.
Next year, Mathieson continues, her group will build tools for collateral allocation, rehypothecation of securities, margin management and the virtual global long box. All told, more than 157 people are working on the project, she reports. J. P. Morgan also has partnered with four vendors -- two that specialize in margin management and reconciliation for derivatives, and two that have user design experience for securities market applications -- to build the collateral management platform. Mathieson declines to identify the vendors.
Ultimately, Mathieson says, J. P. Morgan will have a platform that will help clients make collateral management-related investing, lending and borrowing decisions in a near-real-time environment in several time zones around the world. "It will put much more risk management data directly into our clients' hands that fits into the lending, trading and investment decisions they're making," she asserts.
BNY Mellon Ramps Up for New Clients
Like J. P. Morgan, BNY Mellon also has seen its collateral management business expand. The firm handles more than $1.8 trillion dollars' worth of collateral management business. BNY Mellon's global collateral management services team facilitates the tri-party collateral management process, helping to manage its clients' inventory. It also helps firms manage collateral as a risk mitigant.
Buy-side firms that trade derivatives might not have looked closely at their collateral management process before this September, says Scott Linden, the firm's VP and global product manager, derivatives collateral management. But as they dig out from under the effects of the traumatic month, they will. "There will be an echo effect we'll see into 2009 of people looking closely at their collateral management policies, processes and technologies, and thinking about outsourcing this," he contends. "We're starting to hear a little bit of that as people are coming up for air, but I expect to see a lot more in the next three to six months."
As its technology platform, BNY Mellon leverages a tri-party collateral management engine called RepoEdge that typically traffics cash coming in from investors and securities coming in from dealers. "We work with our clients to ensure that there's a broad array of collateral, and that there's not too much of any particular type of collateral, by screening for eligibility and concentration limits," Linden relates.
BNY Mellon is creating new tools to help counterparties check the status of contracts and collateral. "For example, we're developing an innovative service scheduled to debut later this fall that automatically aggregates and nets overall collateral obligations, which minimizes the collateral dealers are required to post and reduces the risks and costs associated with derivative transactions," the firm's Malgieri says.
Other innovative technology already in place includes BNY Mellon's derivatives margin management product. In production for two years and undergoing further development, the product is typically used by a buy-side institution that is trading bilaterally with several derivatives dealers, according to Linden. BNY Mellon supports the margin collateral process on behalf of these clients. "One of the themes that's come out in the past few months is that when you trade bilaterally, any excess collateral you leave equates to credit risk," he says. "We follow the letter of the law of the ISDA agreement and make sure that if there's excess collateral that our client can call back from that counterparty, we do that." If there's a dispute, BNY Mellon reconciles and identifies the root cause, Linden adds, noting that the firm provides reports and real-time access to a Web-based solution so clients can view transactions.
Such collateral checks are typically required under ISDA master agreements to be conducted weekly, especially for older derivatives contracts. For new contracts, the standard is becoming a daily collateral review. "A lot of the clients we support that have weeklies have an intraweek provision or are changing them to dailies," says Malgieri. "This is a market practice that's been building for a while and will rule the roost going forward."
Collateral management software and services have emerged to help firms enforce collateral agreements. For example, under what conditions does the collateral become collectible? Where does the collateral reside? Who is the contact at the entity that's holding the collateral?
"The contract may have been written in a happier time, when the only issue was, would the counterparty default or not," Accenture's Grau says. "In today's environment, you have to ask, 'Are they part-way through a restructuring? What if there's an acquisition with a counterparty with which we don't want to be in business or to which we're already well exposed?' There are so many variations that were not considered originally that have to be considered."
Mn Services is a fiduciary manager based in the Netherlands that provides asset management services for institutional clients, mainly pension funds. Mn Services, which has approximately US$85 billion in assets, invests on behalf of its clients, advises on portfolio construction, manages their money against a liability benchmark, and hedges their inflation risk and foreign exchange risk in the portfolio with the use of OTC derivatives such as interest rate swaps and inflation swaps. OTC derivatives bring about direct counterparty risk, which Mn Services manages through a strict broker-approval policy, requiring ISDA agreements and enforcing limits on the positions clients have with brokers, according to Muhittin Elvan, the firm's head of risk control.
"We monitor counterparties strictly, and collateral management is part of the risk control department at Mn Services," Elvan says. "We take OTC trading and collateral management very seriously and see it as part of credit risk and counterparty risk management, not just operations."
According to Elvan, collateral agreement terms on the buy side have gotten stricter than they were a year ago. For example, the frequency of valuation and collateral movement is increasing, in some cases to a daily frequency. To prepare for new clients and execute the stricter terms of these contracts, he says, Mn Services earlier this year further automated its collateral management process. Elvan reports that the firm considered the three primary solutions in the space: Kyros from Allustra (which was acquired by Omgeo in September), Colline Collateral Management from Lombard Risk and Algorithmics' Algo Collateral. (Also in this category, SunGard offers a collateral management solution for OTC derivatives called Adaptiv Collateral, and AcadiaSoft offers messaging and workflow for collateral interactions among parties.)
Elvan contends that all three products could do what he needed them to do, but he chose the Allustra product for its intuitiveness and flexibility. "With Allustra you have a good view of inventory, your OTC positions and your collateral," he says, adding that it also features a strong built-in workflow. "It can be very fast and comprehensive."
"You can fully automate the process -- the system reads itself all the OTC positions, the collateral positions, calculates how much collateral should be asked for, and sends requests [via e-mailed PDF] automatically to your counterparty," Elvan says. Everything processed in the system is tracked.
Automating the process, Elvan says, makes it easier to gain insight into positions and inventory. "You could do a search [for] 'Lehman' and see what your positions are, how much collateral you have against all of your positions with Lehman," he relates. "That's the strength of automating collateral management. We found [in September] traders and portfolio managers sitting at our desk many times a day and asking us about their positions and collateral."
The next step for Mn Services in automating collateral management, according to Elvan, will be to gain the ability to stress-test its positions -- for example, if interest rates go up a certain amount, how much additional collateral would be required? "You have to be prepared for stress situations," he says. "Nowadays, every day could be a stress situation."