The concept of collateral has been around for decades, with borrowers pledging assets to protect their counterparts in the event of a possible default on long-term financial obligations. After the U.S. subprime mortgage crisis in 2007-2008, U.S. regulators began to introduce sweeping regulatory reform and recommendations for how collateral should be managed going forward. This included rules and regulations across various asset classes and traded products, including simple and exotic derivative products actively traded in the over-the-counter (OTC) marketplace. The evolving need for robust collateral management processing requires consistency in client onboarding, accuracy in valuation calculations, Straight Through Processing (STP) capabilities, increased transparency to regulators and auditors, and a strong IT infrastructure. As such, buy-side and sell-side firms began to actively invest in their technology and operational processes to accommodate both the increasing volume of collateral and regulatory disclosures and calculations.
Although banks have made great strides in improving their collateral processes, the pandemic proved that more is required to ensure soundness and viability for the future. The pandemic resulted in unprecedented low interest rates which contributed to a large spike in volume of trades and operational processing. As such, there was an increased need for senior leaders to rethink their digital strategy as it pertains to their data management, collateral operations, and technology infrastructure. Like many industries, the banking industry was forced to become even more agile and transform its collateral management operations to ensure stringent monitoring and robust credit risk exposure management, especially in times of high market volatility. Collateral management is intertwined with many different cross-functional groups (see figure 1) and transformation must take into consideration all aspects and create robust workflow capabilities to ensure all groups and data are covered. Input data is key and must be kept up-to-date and managed accordingly to avoid operational data quality issues (See Figure 1 – Section 1). Both buy-side and sell-side firms should look to address the glaring inefficiencies found in current collateral management operations, especially in client onboarding and data. These inefficiencies include manually entering data from legal agreements, manually handling portfolio reconciliations and exceptions, and preparing reports. Figure 1 below provides an enterprise view of the collateral management process today and key inputs and outputs to illustrate the complexities the industry is up against.
Addressing Reference Data Challenges
Increased margin activity in stale and dormant accounts has caused numerous breaches in margin threshold triggers and transfer amounts. The leading cause of this operational challenge comes from known gaps with firms’ reference data found in both agreements and collateral accounts. Account control agreements (ACAs), collateral schedules, and settlement instructions all lack complete data sets required for enhanced investigation and dispute resolutions (See figure 1, section 6). Collateral management operation groups should look to adhere to a set of industry-wide common data model(s) to avoid delays and increase the ease and efficiency to process margin calls.
Streamline Collateral Management Operations and Realize Efficiencies
Firms across the globe continue to face further challenges and operational inefficiencies as middle and back office functions get inundated with margin calls, settlement fails, margin disputes, and portfolio reconciliation issues (see figure 1 – section 6). Manual handling, processing, and intervention along with reactive calls to action have further heighted the need for senior leaders to assess their current operating model(s). Action set forth to operate more efficiently, ensure accurate reporting of collateral pledged, and avoid reputation damage is critical to the success of all firms involved. For example, the recent headlines made by GameStop has called for change to settlement cycle times by the Depository Trust and Clearing Corporation (DTCC). As mentioned above, collateral management processing is interconnected and requires transformation that takes into consideration all cross-functional groups and the impacts in a timely manner in the event of reactive regulatory change, volume, and scalability. In the event of GameStop, reducing settlement cycle time to one day (from two) after the transaction would significantly cut costs for brokers, reduce market risk, and lower margin requirements, especially during times of high volatility (McCrank, 2021). Ensuring accurate valuation and exposure calculations can be challenging given the various data sources. Figure 2, section 1 below recommends centralizing all key data points into a centralized data lake to ensure consistency and speed of calculations. Boosting Straight Through Processing (STP) capabilities by leveraging Natural Language Processing (NLP) can help ensure data is accurate and not dormant.
Last year, the Commodity Futures Trading Commission (CFTC) extended the IM deadlines for the Uncleared Margin Rules (UMR) phase five and six. This deadline extension allows for additional operational enhancements and process improvements to aid in further changes later this year and in 2022. For more information, please click here.
Leveraging Technology to Reach New Heights
Emerging technologies (Figure 2, Section 3) such as robotics process automation, artificial intelligence, and distributed ledger technology will continue to be integrated more and more within collateral operations as firms continue on their digital transformation journey. These technologies not only promise to reduce costs and errors while increasing throughput, they are also critical tools to quickly scale operations in response to rapid and unexpected changes in volatility and trading volume. While implementing advanced technologies may seem daunting and fraught with risk, the best way to get started is looking for automated solutions to the most common breaks that require significant manual intervention to resolve. For example, investing in automation tools that can proactively identify common portfolio reconciliation issues, margin disputes, and settlement fails can greatly reduce overall operational overhead. The ability to proactively identify scenarios where trades are negatively correlated, contain large market swings, or are based on stale mark-to-market (MTM) valuations are all leading indicators for disputes and can be identified and resolved in a more anticipatory manner through automation. Firms that take the time to thoughtfully consider the use technology to address their most pressing collateral management challenges will enhance their operational resilience while best positioning the firm to win in the marketplace.
References
McCrank, J. (2021, February 24). U.S. post-trade group proposes shortening stock settlement cycle. U.S. https://www.reuters.com/article/us-retail-trading-settlement/us-post-trade-group-proposes-shortening-stock-settlement-cycle-idUSKBN2AO1TQ
About Monticello
Monticello Consulting Group is a management consulting firm supporting the financial services industry through deep knowledge and expertise in digital transformation, change management, and financial services advisory. Our understanding of the competitive forces reshaping business models in capital markets and digital banking are proven enablers that help our clients drive innovative change programs to be more competitive and gain market share in new and existing businesses.