Ted Leveroni, Chief Commercial Officer, DTCC-Euroclear GlobalCollateral Ltd.
Is collateral management entering an industrial age? In this Q&A with DerviSource, DTCC-Euroclear GlobalCollateral’s Ted Leveroni discusses the findings of a new report on the topic and explores the need for buy-side and sell-side firms to move up the utility curve.
DerivSource: The recently published report “Derivatives Collateral Management: Entering the Industrial Age” – commissioned by DTCC-Euroclear GlobalCollateral Ltd and conducted by AiteGroup surveyed both buy and sell-side firms on their preparedness for collateral management changes in light of regulatory reform. Where do firms stand in their preparedness for collateral change coming ahead?
Ted Leveroni: The buy side and sell side have historically been working at different speeds when it comes to preparing for regulatory change impacting both OTC derivatives and collateral management operations. The report confirmed that the sell side has come a long way in preparing for compliance with new market requirements under both Basel III and EMIR by centralizing their services, bringing the front office and collateral management functions closer together. It is not surprising to see that this side of the market is well prepared, as the sell side regulatory obligations come into effect very soon. At the same time, the sell side are very aware of the impending collateral squeeze, which could come once clearing in Europe has been implemented. Sell-side firms understand the long-term changes on the horizon and know that it will be a slow evolution for collateral management. They are being diligent in anticipating changes ahead, and approaching them on an industry level. If a sell-side firm were to be starting from square one today – they would face significant challenges in meeting regulatory obligations.
The buy side’s response to the survey was interesting, in that there seems to be a notable variation between the levels of preparedness between firms. Some asset managers have come along way in centralizing their collateral management operations, having automated previously manual functions. However, some firms remain in the business analysis phases so have yet to get started.
The lack of progress for some asset managers may not be as alarming given the range of support services that are available to them. Software vendors and solution providers have been focused on regulatory change impacting collateral management and OTC derivatives for many years and are well placed to help slow movers get started. For buy-side firms who are still in the analysis phase, all is not lost. Asset managers still have 10 to 12 months before regulation under EMIR truly begins for them, so the buy side has some time in to address gaps. These firms should be able to meet the approaching deadline, assuming they are willing to automate the processes that enable them to become compliant.
Having said that, all market participants will definitely feel the impact of market changes once EMIR truly begins, when mandated central clearing becomes a reality and when collateral shortages commence. It is anticipated that European market participants will feel both the pain and pleasure of mandatory central clearing in the same way U.S. market participants did two years ago. In my view, European buy-side firms are learning lessons from the U.S., most notably the problems that occurred due to a lack of engagement with dealers, futures commission merchant (FCMs) and clearing brokers early on in the central clearing process. It seems European firms are focused on lining up their central clearing counterparts now.
DS: The report discusses the industrialization of collateral management. What does this mean exactly?
TL:Industrialization of collateral management refers the fact that there are collateral management processes that need to be centralized and automated internally as well as externally – or “industrialized”. The AiteGroup report defined the part of the collateral processing chain that could be industrialized across firms, and therefore should not be seen as a competitive differentiator, nor should it be considered a cost efficient process to keep in house.
Financial institutions will still need collateral management experts, but we are getting to a point in the industry where we can work together to create standards and facilitate straight through processing from centralized facilities. Some functions may be shared internally and between counterparties, but others have too much differentiation between firms and wouldn’t benefit from a utility approach. For instance, functions that require input from the front office including access to collateral availability and a firm’s funding costs, will vary from firm to firm, so will not be outsourced to a utility.
DS: What is the future of utilities and industrialized functions in collateral management?
TL: over the last several years, software, outsource providers and business process outsourcers (BPOs), have been working diligently to effectively manage the industrialization of activities held within the four walls of an institution. This includes the applied eligibility rules, haircuts, creating the collateral calls and conducting the processes to protect that individual firm. What hasn’t been addressed, however, is the interplay between firms.
For example, AcadiaSoft has enjoyed success in managing the communication component of the collateral process - the calls, messaging and the agreement that counterparties need to send. To some extent, margin messaging via AcadiaSoft has become a standard. Now, the industry needs to focus on the processes that occur after the communication has been initiated. To explain further, AcadiaSoft is a community solution but this piece of the process - the actual collateral movement, the roads and highways that connect the firms to get securities or cash from one place to another – calls for both an industry and community solution as well as standards. That is why Euroclear and The Depository Trust & Clearing Corporation (DTCC) have partnered to create the DTCC-Euroclear GlobalCollateral Ltd. joint venture, with a Margin Transit Utility (MTU) for the processing of margin calls and a Collateral Management Utility (CMU) to support seamless mobility of collateral and settlement.
DS: How does use of a utility help firms improve efficiency of collateral mobility?
TL: Currently collateral is moved on a point-to-point basis, creating a spaghetti-like infrastructure. For example, a dealer or a buy-side institution can have 100 different custodians and 100 clients it will have to connect to, each with their own formats and data. As collateral movements increase in the coming year, this complex and labor-intensive operational approach will near its breaking point for many market participants. It makes much more sense to leverage a centralized hub (or utility) for connectivity as well as data storage, instead of everyone individually storing that information.
A centralized connectivity hub will also become useful when changes occur in the process. Today, if firm changes their addresses, other market participants wouldn’t know unless they were notified, opening firms up to the potential for inaccurate account and standing settlement instructions (SSIs). If firms leverage a central location to store collateral SSIs, firms can update the data just once, helping to promote data accuracy and reducing the potential for fails.
DS: What about the cost?
TL: Individual firms can either create a solution in-house at a significant price, or leverage a community or utility solution at a most cost efficient price. A market utility leverages common standards and automation, so the actual cost of processing collateral should go down. It leverages straight-through processing, and firms immediately benefit from working on an exception basis as opposed to a call-by-call process; this can reduce operating resources over time.
DS: What is the next area of collateral management that should be addressed?
TL: Many market participants have often said, “The general secret of collateral management is collateral fails”. Very often the collateral manager doesn’t realize that their collateral is constantly failing, although the settlements staff do! The settlement team fixes the problems and often spends a lot of energy on finding out where collateral has actually gone.
At the end of the day, some collateral managers view their job as a processor, but really the reason why we manage collateral is to protect ourselves from counterparty default, and the only way you do that is to actually receive the collateral you are supposed to receive. If the process breaks down in the settlements phase, some collateral managers think, “Well, I’ve made my calls, we’ve agreed to it, they’ve sent it, I’m covered.” However, if you have not actually received the collateral, your counterparty fails overnight, that’s all you have. All of the great processes upstream do not matter if the collateral fails, and there’s a significant fail rate.
When you leverage standards and create automation in the collateral management space, especially with managing data and communication around this critical area, fails should significantly decrease because you are working off better data and creating transparency. This means that you should be able to identify if anything is at risk of failing and instead focuses operational efforts at addressing and managing the problem.