Collateral Management
Nidhi Lall

NIIT Technologies White Paper
Executive Summary


Collateral Management and Market Developments


Collateral Management – Features


1. B...



After millions of dollars were lost when the financial institution

Once the market became stable, capital market industry...
Tri-Party Collateral Agreement
Tri-party Collateral Agreement involves third parties during the
transaction. Third party i...
they should be valid enough to provide deemed ratings for

2. Determine eligible collateral for the

collateral. However, ...
• A call for collateral may be initiated by one entity while another

• Type of collateral – Security collateral or cash c...
Build and Buy Systems
Financial institutions struggling hard in collateral management and
OTC derivatives must invest in p...
About NIIT Technologies
NIIT Technologies is a leading IT solutions organization, servicing customers in North America,
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Collateral Management and Market Developments - Whitepaper


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The paper provides a broader view on how technology bridges the gap and also enumerates the best practices that financial institutions must follow to improve collateral management process.

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Collateral Management and Market Developments - Whitepaper

  1. 1. www.niit-tech.com Collateral Management Nidhi Lall NIIT Technologies White Paper
  2. 2. CONTENTS Executive Summary 3 Collateral Management and Market Developments 3 Collateral Management – Features 4 1. Bi-Party Collateral Agreement 2. Tri-Party Collateral Agreement 3. Collateral Trading and Re-hypothecation 4. Repos and Repos Market Collateralized Relationship Structuring 3 1. Credit considerations 2. Determine eligible collateral for the counterparty Implementing the Collateralized Relationship 6 Best Practices 7 1. Revalue Collaterals 2. Maintaining Critical Buy Side Relationships 3. Regular and Frequent Portfolio Reconciliation 4. Outsource Collateral Management 5. Build and Buy Systems Role of Technology in Collateral Management Systems 8 Conclusion 8
  3. 3. INVESTMENT FINANCE CAPITAL BANKING INVESTMENT WEALTH FINAANCE MARKET INVESTMENT FINANCE CARGO CAPITAL ECONOMICS FINANCE REVENUE REVENUE MATKET INVESTMENT CAPITAL CAPITAL ECONOMICS MARKET FINANCE Executive Summary Financial institutions need accurate and sophisticated enterprise wide Collateral use in the market has increased. According to ISDA survey approach to keep their collateral inventory optimized while generating in 2013, the $3.7 trillion estimate of total collateral in circulation is revenue and reducing costs. This paper provides an insight into based on total reported collateral amount of $2.67 trillion. With the Collateral Management, in the current economic scenario. The paper increase in collateral circulation it is important for firms to implement provides a broader view on how technology bridges the gap and also robust, automated collateral management solutions to support enumerates the best practices that financial institutions must follow to evolving market and regulatory needs. improve collateral management process. Growth in value of reported and estimated collateral (USD billion) OTC Contracts Cleared on CCP 4500 4000 3957 3500 3151 3652 2934 2649 3000 2150 2500 2000 2459 3700 2666 Collateral Management and Market Developments Collateral is any asset that is used to secure a borrowing. It is a 1984 guarantee that the cash borrowed by the counterparty would be 1500 returned back at the predefined time. When two parties engage in 1000 Collateral Agreement, the lender reduces Credit risk while lending 500 cash and the borrower gains favorable conditions for financing. 0 2009 2010 2011 2012 2013 Year Estimated Collateral Management assists organizations to mitigate Credit risk, by accepting a similar valued asset in return for the loan/cash Reported lent. Collateral Management reduces risk between the lender and Banks and Financial institutions are under immense pressure in every area of their business with the introduction of new rules and market changes from the Global regulators. With ~90% of firms reeling under pressure from aggressive regulatory changes and the borrower and is effective when it constantly rebalances exposure as per changes in prices and regulations. Collateral Management has developed as a strong Business practice that forms the core aspect of the organization. over 35% facing compliance, administrative and reporting burdens (Celent, 2013), collateral management has become the top priority for the banking and capital markets industry. It is no longer recognized as a back office function but has evolved as a major challenge for both banks and financial institutions to convert outmoded spreadsheet based systems to an automated and advanced collateral management system. Collateral Management has undergone a major transformation after the collapse of Lehman Brothers and the onset of the financial crisis. The credit crisis of 2008-09, along with freezing of credit markets and increased volatility resulted in the introduction of new regulations (BASEL III, CRD IV, EMIR and Dodd Frank Act) and high volumes of collateralized loans. In Europe, banks had a shortfall of €374.1 billion (Quantitative impact study by Basel Committee, Sep 2012) to 75% Dodd-Frank 65% EMIR comply with additional liquidity requirements of Basel III. Exerts biggest impact on the economics of trading derivatives 3
  4. 4. After millions of dollars were lost when the financial institution Once the market became stable, capital market industry started Lehman Brothers collapsed, industry demanded better collateral considering collateral management as a core function fully management. Industry initiatives required firms to consider integrated in the management of financial institutions and closely smarter ways of using the limited collateral available. Financial linked to treasury, trading, risk management, operations, finance institutions were forced to focus on counterparty credit risk and and capital management. the wide use of derivates and the entire collateral management process. Regulatory changes also called for additional collateral and margin requirements for large and complex derivatives. The Collateral Management – Features implementation of global regulations such as Dodd Frank Act, Collateral Management has evolved for hundred of years, from a EMIR and other capital regulations emphasized to automate the single, ancillary function of an organization to cover a collateral management systems in order to manage them with comprehensive list of functions and features. Some of them are: ease. Automating collateral management systems mitigated systemic risk and increase transparency in Over-the-Counter (OTC) trades, and pre- and post-trade financial transactions. However, to prepare for the changes firms needed investment in technology. Technology helped firms in looking at the collateral holistically and facilitated clearing. According to a survey by a research firm Celent in 2012, an estimated 40-50% of OTC Bi-Party Collateral Agreement Tri-Party Collateral Agreement contracts are expected to be cleared by the end of 2013, leaving a $2.5 trillion to $6 trillion collateral hole to fill. Centrally Cleared OTC Contracts Will Leave a $2.5 Trillion to $6 Trillion Collateral Hole to Fill OTC Contracts Cleared on CCP 90% 80% Repos and Repos Market 80% 70% 70% 60% 60% 50% 40% Collateral Trading and Rehypothecation 40% 50% 30% 20% 10% 0% 2012 2013 2014 2015 2016 Bi-Party Collateral Agreement Bi-Party agreements are collateral agreements where two Source: Morgan Stanley, Oliver Wyman, Celent parties interact among themselves and form a collateral The enterprise collateral management challenges from the agreement without any interference from a third party or a inefficiency of collateral silos also resulted in the implementation of centralized bank. The Bi-Party Collateral Agreements are over new processes and procedures to manage current and future the counter agreements customized according to the needs. It collateral management needs. There was an immediate need to is a two-legged transaction – Initiation of the Agreement and link collaterals to credits. After the financial crisis, the amount of Termination of Agreement. uncollateralized credit available between transacting counterparties has sharply fallen down. Decrease in the uncollateralized credit increased the demand for collateralized credit, which in turn generated interest in the mechanisms available to support collateralized solutions. 4
  5. 5. Tri-Party Collateral Agreement Tri-party Collateral Agreement involves third parties during the transaction. Third party is an intermediary during the entire process and usually the Custodian Bank of the firms. The Custodian bank is the safe-keeper of the Collateral for the Lender, Collateralized Relationship Structuring 1. Credit considerations Structuring of collateral relationship involves credit considerations to be followed. These considerations are: and assists in transferring funds from the Lender to the Borrower. 1.1 Is collateral a suitable credit enhancement tool? Triparty Collateral Management To determine whether collateralization is appropriate, financial The Collateral Management Outsourcing Solution Bi-lateral Contract Triparty Service Agreement Collateral Giver institutions must analyze the counterparty’s financial position. It is important for firms to note that collateral does not turn a bad Operating Procedures Terms and Conditions Eligbility profile Concentration profile Margin percentages Neutral Agent Collateral Taker counterparty into a good counterparty without eliminating credit risk. A collateral arrangement provides assets of value during Eligibility Set 1 • Eligible: AAA - A • No concentration • x % haircut Eligibility Set 2 • Eligible: AAA - BBB • only y % of BBB • z % haircut counterparty’s default or bankruptcy/insolvency. A financial institution loses funds only under a fully collateralized arrangement. If the direct counterparty defaults during the default period (prior to liquidation of the collateral), there is a significant increase in MTM exposure or decrease in collateral value held after taking into account independent amounts (initial margin) and haircuts on the Collateral Trading and Re-hypothecation value of the collateral securities. Collateral Trading is done to free resources for working capital requirements by the bank. It traditionally involves few market participants and represents a very small proportion of total trading. Re-hypothecation, on the other hand, is the process where the secured lender extends the collateral posted, by either lending or posting it as collateral to another party. It is also done to free up collateralized capital. 1.2 Determine the Credit Type of the Counterparty It is always helpful to determine the counterparty’s ability to • Deliver collateral on a timely basis or hold collateral • Measure collateral requirements on a daily, weekly or monthly basis. 1.3 Determining the Appropriateness of Collateral Upon successful completion of credit analysis and gathering of Repos and Repos Market Repo is an agreement in which one party sells securities or assets to counterparty and simultaneously commits to repurchase the same at an agreed time. The repurchase price is equal to the general counterparty information, the credit officer must determine whether the collateral is an appropriate credit enhancement tool. He must identify appropriate credit support terms to negotiate. In some instances, other provisions, such as guarantees or an option to terminate the transaction may be helpful. original sale price plus interest on the repurchase price. 5
  6. 6. they should be valid enough to provide deemed ratings for 2. Determine eligible collateral for the collateral. However, revealing credit ratings may have confidentiality counterparty 2.1Considerations for Selecting Appropriate Collateral Appropriately selected collateral gives financial institutions implications. Therefore, confidentiality of the use of internal credit ratings must be agreed upon between counterparties before they are shared with the outside world. protection against counterparty risks and may reduce capital costs. Poorly selected collateral gives rise to unacceptable levels of price risk, liquidity risk, operational risk and legal uncertainty. The following criterion has been used as a basis for determining collateral eligibility. as the S&P500, the FTSE100, DAX30, CAC40 or Nikkei 225) is 2.1.4 Instrument Tenor (Time Remaining to Mature) Firms should consider credit rating, currency, issue size and the frequency of price updates to understand the liquidity of the collateral. If the price for a particular item of collateral is not available, the firm must interpret it as a significant downturn in the liquidity of that asset. It is advisable to establish a liquidity threshold below which an item of collateral is valued as zero. Collateral is group of tenor buckets with tenors measured as residual maturity rather than original maturity. Existing collateral agreements refer to original maturity but measure residual maturity suggesting a need to amend the agreement. However, in this dispute of original maturity vs. residual maturity oral arrangement may not be enforceable. 2.1.2 Volatility volatile on the major exchanges and especially in the prime indices (such generally viewed as indicating greater liquidity of the collateral. 2.1.1 Liquidity Highly Collateral quality is difficult to gauge for equities. However, listing 2.1.5 Avoid Strong Correlation to Exposure instruments should be subject to lower concentration limits and higher haircut rates in order to be accepted. The haircut computation methodology ensures that the price volatility is factored into the haircut. When establishing initial margin levels or haircuts, it is important for the firms to understand that operational risk is generated by the delay between the time at Collaterals with strong correlation to underlying exposure are not appropriate as their value always decreases when the exposure increases. These collaterals are always unacceptable even if they qualify under all acceptability criteria. In certain circumstances, the collateral chosen may specifically offset the liability because of its strong correlation to the liability, creating a covered trade. which a margin call is made and the time at which the collateral is delivered. During periods of extreme market volatility, if the 2.1.6 Avoid Positive Correlation to Collateral Giver collateral call is made on day T while delivery of the collateral will Any collateral whose value correlates directly and positively to the not take place until T plus one day, a lag of one day will create collateral giver’s credit standing is usually not acceptable. operational risk. It is, thus, inadvisable to accept collateral subject Securities or any related equity issued by the collateral giver is to long settlement periods. Initial margin levels and haircuts should normally not accepted as collateral. be established at all levels to take account of this risk. 2.1.3 Collateral Quality (Credit Rating) a bond is not rated by an agreed rating agency (e.g. S&P or Moody’s), Implementing the Collateralized Relationship the bond should undergo a deemed rating process. In deemed rating Collateral management complicates the handling of relationships process, firms must review ratings accorded by an agreed rating between two parties under one agreement for one line of business. agency to senior unsecured issues by the same issuer, and accord a A firm may be doing business with the same counterparty out of similar deemed rating if the issue in question is not subordinated. If the multiple entities in different jurisdictions for tax, accounting, issue being assessed is subordinated, the deemed rating is two to regulatory or other reasons. A minimum acceptable credit rating is often stipulated for all bonds. If three modifiers lower than the rated issue. Due to volatile market and jurisdictions, collateral management has An alternative source is credit department of a financial institution. to resolve the following issues that may arise: If • Counterparty initiates multiple calls for collateral to secure credit decisions are based on internal risk ratings, various exposures; 6
  7. 7. • A call for collateral may be initiated by one entity while another • Type of collateral – Security collateral or cash collateral Security entity is returning collateral to the same counterparty. At this collateral including accrued interest should be revalued while time, both the parties run the risk of over collateralizing on a net cash collaterals exclude accrued interest while revaluation basis; and • Market conditions - Time, Market volatility, Finance availability, • Relations with counterparty may be governed by multiple Economic environment, Lack of maintenance etc. agreements with different terms covering different products that may overlap. Maintaining Critical Buy Side Relationships Relationships for the buy-side are extremely critical for Monitoring collateral positions and tracking collateral movements requires both parties to have systems that can handle collateral. Firms need to automate the entire collateral management process. With automation, additional administrative burdens come in the understanding collateral demands in both bilateral and central counterparty world. Hedge funds, asset managers and insurance companies still look at primary service providers to offer best deals across multiple products on a holistic basis. form of monitoring or tracking the securities that are subject of a collateral agreement, performing daily MTM calculations and handling margin calls. Regular and Frequent Portfolio Reconciliation Detailed portfolio reconciliation should be performed regularly or prior to the first margin call. If it is not done regularly/frequently, the collateral that flows back and forth is based on the estimate of the Best Practices exposure; which is not considered a sound basis of collateralization. Revalue Collaterals Regular portfolio reconciliation reduces the frequency of collateral disputes. In order to resolve collateral disputes, the Maintain Critical Buy Side Relationships most effective way is to extract trade files from the collateral system on a regular basis. Regular and Frequent Portfolio Reconciliation Outsource Collateral Management Outsource Collateral Management Fewer than 50% have outsourced collateral management, 25% Build and Buy Systems have deployed vendor collateral management solutions internally, with the remainder reliant on bespoke applications and spreadsheets (ISDA, 2012). In an outsourced collateral management system, it is easy to retain bilateral relationships with Revalue Collaterals Financial institutions must revalue and monitor collaterals against outstanding debt on a regular basis. The frequency of revaluation will depend on the following two factors: preferred counterparties. The outsourced solution will also enable counterparties and investment manager to focus on making strategies rather than worrying about the operational, regulatory reporting and transaction requirements. 7
  8. 8. Build and Buy Systems Financial institutions struggling hard in collateral management and OTC derivatives must invest in plug and play type of systems. They can purchase or lease systems locally or via a hosted solution from a dedicated or a bundled service provider. The systems developed • Scalability and economies of scale to handle increased volume of collateral • Capability to efficiently calculate Mark to Market calculations • Risk management and alert mechanism with audit features to handle market volatility by service providers can be customized to meet the collateral management services needs. Build and Buy systems strategy is the most popular technology strategy with core functionality integrated into existing systems. • Reporting capabilities to handle legal and documentation requirements • Capability to manage disparate systems, data capture from several sources, margin call calculations etc. Role of Technology in Collateral Management Systems Technology plays a critical role in Collateral Management Systems. Collateral management requires compatibility and seamless integration with third party platforms and applications like Order and Trade Management, Trading Platforms, Risk Management Systems and External data feeds for running the business in a seamless manner. A centralized system can process and manage Conclusion The changing regulatory and trading environment has necessitated the need to revisit the existing collateral management processes that involves integration with third party institutions, platforms and applications. It involves precision, accuracy and timely flow of data to margin management and calculation systems. Any discrepancy in data can result in financial institution insolvency. collateral requirements and at the same time handle increased volumes and agreements. In the current market scenario, technology • Improves the efficiency of information and allows market data to move swiftly • Makes the system efficient and capable of handling mark to market calculations • Achieves cross product netting, collateral optimization and management of new regulation requirements. Collateral management is not a perfunctory back office function but considered a core function. NIIT Technologies with 15000 + person years of experience in capital market domain have in-depth expertise in regulatory and change management functions. We evaluate the existing systems and identify the shortfalls. NIIT Technologies provide services in the area of collateral management, third party feeds and data provider integration, enterprise data management, order and trade management, risk management, fund accounting, margining and netting, and reporting. The collateral management systems should evolve in technology with changing times and should always reflect the true picture of A solution that mitigates risk, processes collateral information the market. It should integrate all functions like business consistently across clearing methods and asset classes, and operations, legal documentation etc. to ensure that the system has meets new regulation and industry best practices can core functional capabilities. dramatically change the dynamics of the collateral management market. NIIT Technologies has the know-how and solution to A typical collateral management system should provide develop and automate the collateral management process with • Integration with market data feed providers proven industry knowledge. These strengths have led to a large • Integration with all third party platforms and applications ecosystem with a large number of partners utilizing our • Integration with third party institutions involved in collateral collateral management systems. agreements 8
  9. 9. About NIIT Technologies NIIT Technologies is a leading IT solutions organization, servicing customers in North America, Europe, Asia and Australia. It offers services in Application Development and Maintenance, Enterprise Solutions including Managed Services and Business Process Outsourcing to organisations in the Financial Services, Travel & Transportation, Manufacturing/Distribution, and Government sectors. With employees over 8,000 professionals, NIIT Technologies follows global standards of software development processes. Over the years the Company has forged extremely rewarding relationships with global majors, a testimony to mutual commitment and its ability to retain marquee clients, drawing repeat business from them. NIIT Technologies has been able to scale its interactions with marquee clients in the BFSI sector, the Travel Transport & Logistics and Manufacturing & Distribution, into extremely meaningful, multi-year "collaborations. NIIT Technologies follows global standards of development, which include ISO 9001:2000 Certification, assessment at Level 5 for SEI-CMMi version 1.2 and ISO 27001 information security management certification. Its data centre operations are assessed at the international India ISO 20000 IT management standards. NIIT Technologies Ltd. Corporate Heights (Tapasya) Plot No. 5, EFGH, Sector 126 Noida-Greater Noida Expressway Noida – 201301, U.P., India Ph: + 91 120 7119100 Fax: + 91 120 7119150 Americas NIIT Technologies Inc., 1050 Crown Pointe Parkway 5th Floor, Atlanta, GA 30338, USA Ph: +1 770 551 9494 Toll Free: +1 888 454 NIIT Fax: +1 770 551 9229 Europe NIIT Technologies Limited 2nd Floor, 47 Mark Lane London - EC3R 7QQ, U.K. Ph: +44 20 70020700 Fax: +44 20 70020701 Singapore NIIT Technologies Pte. Limited 31 Kaki Bukit Road 3 #05-13 Techlink Singapore 417818 Ph: +65 68488300 Fax: +65 68488322 Write to us at marketing@niit-tech.com www.niit-tech.com D_45_151113 A leading IT solutions organization | 21 locations and 16 countries | 8000 professionals | Level 5 of SEI-CMMi, ver1.2 ISO 27001 certified | Level 5 of People CMM Framework