As stated by the International Capital Market Association in April 2014, new regulations are having an impact across all areas of collateral fluidity.

OPTIMIZATION: AN OPPORTUNITY FOR BUY SIDE TO TAKE ADVANTAGE OF THE COLLATERAL SHORTFALL

Author: Matthieu Baudoin, product manager, SunGard’s Apex Optimizer solution

A version of this article originally appeared in Investment & Pensions Europe.

As stated by the International Capital Market Association in April 2014, new regulations are having an impact across all areas of collateral fluidity. Collateral providers are facing increasing capital requirements due to Basel III and Solvency II, leading to a global reduction of the high grade assets available and higher costs for transforming riskier assets into those usable as collateral. At the same time, the collateral needs are increasing with the introduction of initial margins and the effect of the high quality assets scarcity on haircuts.

The operational chain is also under pressure as central clearing moves from T+1 processes to intraday margining, while rules on re-hypothecation and collateral segregation ask for more sophistication in inventory and allocation monitoring.

The increasing demand for high quality collateral has a direct impact on portfolio allocations. The need for cash or short term liquid assets may distort portfolio balances by giving an overly high weighting to the non-invested part of the funds. Diversifying collateral becomes more important to reduce the regulatory drag on alpha and portfolio returns.

In its report published in March 2014, “Guidelines on ETFs and other UCITS issues,” ESMA revised its position on the diversification of received collateral for UCITS funds. This decision should ease the use of non-cash as it exempts managers applying the 20% issuer concentration rule on received collateral.

The first challenge to optimal collateral processing is global collateral fragmentation. We should distinguish market fragmentation from the internal fragmentation due to “siloed inventories.”

Several initiatives are currently reducing market fragmentation – such as collateral hubs. Enhanced services offered combine collateral management, transformation operations and delivery automation to network members. The harmonization of settlement rules, through projects such as T2S, which will provide a better fluidity of the collateral workflow.

For the buy side, the benefit of outsourcing the operational flow to third parties should be balanced with an increasing need for cost transparency and controls on inventory.

There is an increasing demand for tools aimed at forecasting collateral needs through what if scenarios or even before entering trades. Such analytics will help buy-side traders selecting optimal prime brokers and central clearers for a given derivative deal.