Collateral management is becoming increasingly important in a commoditised market, especially in Europe. Frances Maguire finds that Europe’s fragmented infrastructure and lack of netting have created the need for outsourced collateral management.
The efficient management of collateral is so critical to the core business of banking that it seems appropriate to question why a bank would consider outsourcing it. Part of the answer is that, according to bank and broker surveys, the fully allocated annual cost incurred by back offices for the selection, allocation, settlement and administration of collateral is estimated to be about $650,000 for every $1bn of transactions. Another part of the answer is that, as markets become more commoditised and margins tighter, the real proof of a bank’s success is increasingly found in the efficient management of collateral.
Although the US benefits greatly from reduced collateral management needs through netting, Europe’s fragmented infrastructure and lack of a single market means that moving and managing collateral efficiently across the various central securities depositories (CSDs) is operationally hazardous.
The larger banks have built systems that enable them to manage collateral more efficiently internally though centralised reporting across the various assets classes. Many banks are still operating in silos, however, adding extralayers of complexity. Already, the larger banks have realised that one of the fastest routes to greater collateral efficiency is through netting, which minimises the amount of collateral being moved throughout the day. Even though it is not always possible to net at customer level, banks are mimicking netting through the use of ‘convenience margining’.
Saheed Awan, Clearstream ‘I challenge any major bank to access the thousands of pieces of collateral that Clearstream can access’
Netting in the US
Stuart Goldstein, managing director of corporate communications at the Depository Trust & Clearing Corporation (DTCC) in the US, believes that netting is the key to enabling efficient collateral management. Unlike the European depositories, the DTCC does not offer collateral management services other than a system to enable its user firms to see the netted result of their transactions.
“We believe that banks are best placed to manage their collateral and, as such, we do not offer collateral management services. With the netting factor at 97% most days, we do not believe that the DTCC needs to be anything but a utility.”
Instead of the full service outsourcing services offered by the depositories in Europe, the DTCC offers its Collateral Management System (CMS) through direct connection via the internet to provide users with information on what factors went into determining the collateral required, such as value-at-risk and market maker domination information, and making preliminary informationon the calculations available earlier in the day.
Michelle Doscher, director, securities lending and cash management, at Instinet Clearing Services, says being able to move cash electronically through the CMS provides significant cashmanagement benefits. “And, in terms of managing our own risk, seeing how collateral requirements have been calculated is also helpful,” she says.
Different tack in Europe
In Europe, the situation is very different. Both international central securities depositories (ICSDs), Clearstream and Euroclear, offer such services and state that banks should seriously consider outsourcing collateral management from the back office. Both have built outsourcing resources that they say are better at managing the requirements of collateral management in today’s markets, negating the need for banks to build the operational requirements from scratch and opening up a much larger pool of eligible collateral.
For Saheed Awan, director and head of global securities financing at Clearstream Banking, the choice is a stark one: building a collateral management infrastructure from scratch now is unthinkable. “It is very difficult to achieve collateral management across split systems, products, functions and business units in organisations where desks and trading books have traditionally managed their own collateral.
“If an institution were to build an in-house solution, they would have to build the capability to, for example, manage deliveries and returns, handle substitutions, reconcile exposures and depository positions, manage fails and handle corporate actions and manufactured coupons,” he says.
Many of the large banks have built such a system and believe it to be central to their operations. Even so, Mr Awan believes that Clearstream Banking is better placed to mobilise thousands of types of collateral than the back office of most banks, including the large ones.
“I challenge any major bank to access the thousands of pieces of collateral that Clearstream can access – it would simply overload their back office systems,” he says.
Clearstream has 68 firms using its tri-party services for repo (cash) and a further 17 firms signed up for all other collateral types (non-cash). Within this, the largest banks are its biggest users.
Automatic selection
Customers can either select and propose the collateral themselves or allow Clearstream to select appropriate and sufficient assets automatically for different transactions on their behalf. The collateral trading desk needs only to notify Clearstream of new transactions. The search for appropriate and sufficient assets then becomes Clearstream’s responsibility.
“This method makes it possible to mobilise literally hundreds of collateral pieces throughout a 24-hour day for a number of transactions – a proposition that would be uneconomic for an average back office,” says Mr Awan.
Likewise, Euroclear enables automatic selection through its AutoSelect mechanism. About 150 banks, including more than 50 commercial banks, use Euroclear’s tri-party collateral management services, which were launched 11 years ago.
Michel Boving, head of collateral management at Euroclear, says: “The vast majority of our users choose automatic selection of collateral type. In fact, more than 85% use AutoSelect and that figure is growing all the time.”
Michel Boving, Euroclear ‘For our collateral givers, who else but the settlement agent – us – is closest to their inventory?’
Large banks sign up
Initially, the Euroclear outsourcing service was primarily aimed at banks that did not have sufficiently developed back offices to cope with the complexities of managing collateral in Europe. Now, says Mr Boving, it has grown to encompass even the largest banks.
“Top-tier banks are now the biggest segment of Euroclear’s user base,” he says. “The reasons for this are threefold: we offer them greater sophistication and complexity of collateral, greater flexibility in the availability of eligible collateral daily, and we allow banks to offer fully-integrated collateral management and settlement, which they could not do without a third party.
“For our collateral givers, who else but the settlement agent – us – is closest to their inventory? This greatly adds to the efficiency with which the giver can optimise its collateral managementand gain access to a larger inventory,” he says.
The bulk of collateral management is still bilateral but tri-party services are continuing to grow and eat into the former. Although it makes sense for smaller banks and new entrants to go the tri-party or outsourcing route, both ICSDs are finding that the biggest users are the large banks.
Mr Awan believes this two-pronged approach will continue for some time as the large banks seek to reap a return on their investment in systems and back office staff. But he believes they will also use tri-party services as well, simply to access greater liquidity.
“Collateral is nothing unless it can be mobilised to get cash or liquidity, and we offer direct access to that pool of liquidity at a lower rate than they can get themselves,” he says.
