Firms that can lend against a wider range of repo assets may also gain business in other areas as investors’ cash is put to use elsewhere. Rajen Shah, senior vice-president and head of securities collateral management at JPMorgan Investor Services, claims that market events like the Enron and Russian crises have already shown that collateralised lending has proven itself to be the safest and most solid way to lend and finance. “For that reason alone, we see enormous growth potential in the repo market – Basel II, the EU collateral directive and other initiatives will provide an added impetus.”
Mixed reaction
However, even though projects like Basel II are looming and despite the evident value in integrating collateral management functions, few banks are yet set up to handle a diverse range of pledged collateral. “Enterprise-wide collateral management is something that the whole industry is looking at and, although it is clear that this will provide tremendous savings and opportunities, they are doing so with varying degrees of urgency,” says Mr Shah. “Some pockets of the market, particularly the hedge fund community, have pushed forward on this while other organisations have been slower.”
Godfried de Vidts, global funding co-ordinator at Fortis Bank in Brussels, president of ACI (The Financial Markets Association) and chairman of the European Repo Council, believes there is an “unbelievable amount” of potential to be unlocked by integrating all collateral management functions ahead of these moves and alongside the explosion of over-the-counter (OTC) derivatives trading. However, he is disappointed by the rate of progress. “Banks are being quite slow to react to this,” he says. “A few of the large players tend to have integrated collateral management systems that can deal across asset classes but beyond this small group, hardly any have such systems in place. Liquidity and collateral management is, surprisingly, still very new for some banks. I am amazed how few banks have made substantial advances here.”
Mr Shah has at least one explanation for the slow reaction: “There is still enough low-hanging fruit in the repo, bond and money markets, so enterprise-wide collateral management has not been a priority for everyone, but that will soon change. Once others see that it can add sufficient value or that its absence could cause them to miss opportunities, then I believe they will react quickly,” he says.
Comprehensive definition
Mr de Vidts defines collateral management as: the optimal management of credit, collateral and capital, all the related execution, operational, documentation, risk management and pricing aspects of a portfolio covering all products divisions and locations. Viewed in such a comprehensive way, it is easy to see why he is disappointed with progress so far. Investors (hedge funds, in particular) are increasingly seeking to include other assets in their accepted and pledged collateral portfolios, particularly corporate bonds, equities and asset-backed securities (ABSs).
“Central banks are also looking to do the same,” says Mr de Vidts. “And, although the European Central Bank does not accept equities yet, it is soon going to accept loans; and for banks to make their repo processes easy, simple and cost efficient within that environment, they will need to integrate these businesses.”
According to Mr de Vidts, Basel III, which is already being considered, may include real estate and commodities as collateral – a move that will require a sizeable change from the status quo. He believes that one of the key reasons that there has been so little change is that at many banks – including some of the major triparty agent banks – bonds and equities are still kept quite separate. “Another problem stems from the separation of the triparty and repo desks, which is not necessarily helpful. Some banks’ repo desks do not even use their own triparty services, which impedes the development of collateral management business,” he says.
Advanced progress
Among the banks that have made the most significant advances is Dresdner Kleinwort Wasserstein (DrKW), where a collateral management group has been formed to manage access to all asset classes – from ABSs and collateralised debt obligations (CDOs), through to emerging market debt, government bonds, bills and equities. DrKW created the short-term products/treasury group in 2002, within which sits credit financing and collateral trading, an integrated collateral management group. Since its inception in Frankfurt two years ago, the group has established a desk in London focused on ABSs, corporate bonds and CDOs, and another in New York for emerging market debt. At an umbrella level, the group pools all assets and offers financing and borrowing across all the asset classes from one single point.
Ulf Bacher, global head of short-term products/treasury, principal trading at DrKW, says: “We believe that this set-up ensures not only a better service to our customers, who are looking for more financing services across different asset classes, but that it also guarantees more efficient in-house financing. All types of collateral have a different financing value or cost and this can only be realised by one specialised financing desk. That is what we have and I am sure that more banks will follow this set-up.”
Ulf Bacher: DrKW’s integrated collateral management ensures better service to customers
Mr Bacher believes there are two key drivers for the inclusion of more asset classes: customers and the banks themselves. “Customers are moving further and further away from traditional investments and trading products, such as government securities and equities, towards credit and structured products. One of the most important requirements for these asset classes is a means to finance them so, to win this new business, banks have to offer a financing capacity,” he says.
Although banks can, in theory, offer financing through the unsecured markets, this will become more expensive because they will need to put more capital against it. So firms will be forced to look for alternative financing instruments – not only for all the assets on their own balance sheets but also for customers. “Repo across asset classes could be the answer to that problem,” says Mr Bacher.
Structured for success
Another bank that has an advanced set-up is Barclays Capital. Its collateralised finance group (CFG) embraces repo, equity prime brokerage and stock lending, fixed income prime brokerage, futures, equity derivatives, and a product development group focused on global netting.
Tim Keenan, managing director in CFG at Barclays Capital in New York, says the group’s history and an early realisation that combining disciplines in a collateralised finance group was an optimal structure explain its current set-up. The CFG dates back to 1997 when the bank sold its equity unit and subsequently bought a prime brokerage business.
“At this stage, we had the luxury of deciding from scratch how to [organise] the collateralised financing business and decided this would be the optimal structure,” says Mr Keenan. “While it was very unusual at the time, we recognised even then that this sort of set-up would be necessary going forward, not only internally but from an external perspective. Clients, and particularly hedge funds, would – and now do – demand it.”
Mr Keenan says that because the CFG effectively places all the bank’s financing businesses under one umbrella, it enables the bank to interlink all collateral products together, offering the best and cheapest form of funding and the most efficient and economic means of access to all forms of collateral.
“Our global netting product distinguishes us from our competitors and gives us the ability to offset against and between products. From a customer perspective, this is very attractive, and we undoubtedly attract and retain clients because of this. In the future, our competitors will have to offer the same because it will be critical to have this type of structure to meet the demands of the fast-growing repo universe,” he says
Silo barrier
Although Mr Keenan describes the decision to establish a similar structure as being a “no-brainer”, he admits that, for many other banks, it may not be easy to do so because of existing product silos.
Mr Shah believes that product silos are partially responsible for delaying banks’ progress but he expects that to change gradually as the focus on collateral optimisation increases. “There will not be a Big Bang type change but there will be gradual advances from different sectors as the trading line silos are broken down, which will lead to much broader enterprise-wide netting,” he says.
The triparty route
Triparty services will be crucial to breaking down these silos, according to Mr Shah. He believes that triparty can help banks to put the shift to integrated collateral management into effect. “Breaking down the silos can be politically difficult and demand significant investments, but triparty can effectively eliminate the silos at a collateral level, so that cross-asset optimisation can be achieved even while the trading silos remain in place. And if this is supplemented with sound management information and reporting systems, the collateral can be utilised almost as effectively as if the silos were not there.”
Representing one of the largest triparty businesses, Mr Shah is clearly evangelical about the benefits that the service can bring to those attempting to implement efficient cross-asset collateral management groups. Nonetheless, his arguments are powerful. “The diversification of the repo product into new asset classes is inevitable but it will involve much more administration and risk management because ticket sizes will be smaller and credit quality will reduce. Triparty agents can monitor concentration risks and run the automated processes to deal with smaller ticket sizes and substitutions. Why pay more, incur greater risks and lose liquidity by managing collateral in-house when collateral management is not a core competence?” he says.
Many banks will undoubtedly opt for Mr Shah’s triparty route as a quick means to grow collateral management functions, bolstering the existing $3000bn worth of assets that are lining triparty agents’ purses, while others may attempt to effect the changes in-house, as DrKW and Barclays Capital have done. In the meantime, the gains will be firmly with those that have already made the change.
“We are undoubtedly able to take advantage of a lot of trading opportunities by looking at all these things together, which many of our competitors are missing out on,” says Mr Keenan. “And, although I think that most of the market will have set up similar financing and collateral management structures within three or four years, the prize will be held by the first movers.”
