In brief
- Challenging economic conditions are intensifying the need for efficient resource allocation and risk management strategies at financial institutions
- Collateral optimization is essential for enabling capital efficiency, lower funding costs and increased resilience in turbulent market conditions
- Discover the real-world benefits of collateral optimization, the challenges to consider and strategies for adopting streamlined, data-driven collateral management
What is collateral optimization?
Collateral optimization is a set of policies and processes enabled by technology solutions to maximize collateral management’s efficiency. Optimization ensures that your collateral assets are allocated as efficiently as possible to meet margin calls, minimize costs and risk exposure and maximize revenues.
Efficient collateral management quickly determines which assets can be committed as collateral to execute a transaction. It should allow you to identify and minimize the cost of collateral pre-trade and the cheapest-to-deliver collateral post-trade. Some firms target the liquidity coverage ratio. Others benefit from rebalancing the capital structure or automating cheapest-to-deliver asset identification.
Who needs collateral optimization?
Here are some clear signs you need an optimization strategy:
- Your collateral management infrastructure is fragmented, comprising multiple siloed systems
- Human-error-prone collateral management processes take too long
- Analysis and forecasting for collateral inventory and obligations are routinely delayed
- You’re more likely to miss margin calls than your peers
- Reference data is incomplete, stale and supplied with substantial delays
- Settlement fails are rising
Five best practices for collateral optimization
1. Enabling organization-wide collateral visibility
All collateral data needs and inventory across asset types, business lines and jurisdictions should be consolidated into a single solution instead of being locked away in disparate systems. Only a centralized data repository on collateral eligibility, margin requirements and inventory can enable comprehensive analytics and data-driven decision-making for all levels.
You can consolidate all collateral management data using a platform that connects to existing systems and can extract the required data. However, that data must be continuously verified and standardized to ensure reliability and usability.
To maximize their value, the pre-trade and post-trade data should be sent to the collateral management system in real- or near-real-time. With virtually instantaneous data availability, a full view of collateral obligations, adjustments and inventory will inform your decision-making.
2. Verifying data quality
To become a valuable asset, all the data pulled from other sources, whether internal or external, has to be:
- Complete (no missing entries or values)
- Unique (no duplicate entries)
- Valid (in a supported format)
- Timely (made available within a specific timeframe)
- Accurate (error-free and matching the source of truth)
- Consistent (not contradicting other data sources and other metrics)
- Fit for purpose (matching the business purpose)
To ensure data quality, data entries must undergo a verification and validation process before being added to the consolidation platform. Some data transformations might be required to ensure uniformity and standardization.
3. Integrating with other systems
Integration with other systems is essential for facilitating the easy flow of collateral data regarding:
- Available capital
- Pricing
- Portfolio performance
- Counterparty financial health
- Cleared deals
Data sources typically include brokers, central counterparties, market infrastructure, clearinghouses and, possibly, treasury and securities financing systems.
4. Implementing comprehensive analytics
Efficient collateral management goes hand-in-hand with making a comprehensive set of analytics tools available to decision-makers at all levels. These analytics tools include:
- Forecasting: With the help of predictive analytics, the solution can automatically assess credit risk for a particular transaction and predict portfolio performance and funding needs based on multiple scenarios. These forecasting capabilities should include what-if modeling and stress testing for trade, margin and collateral levels
- Automated collateral recommendations: Allocating collateral can be streamlined with the help of a collateral optimization algorithm that leverages analytics. This algorithm analyzes the transaction parameters, recommending the most suitable collateral based on predetermined criteria
5. Automating manual processes
Automation takes in every aspect of collateral optimization, from netting and substitution to margin reduction and pricing calculations. Here’s how automation streamlines collateral management:
- Automated margin and pricing calculation: The system assesses the transaction’s parameters (including risks) to calculate margins and provide detailed costs for each case. Granular pricing is based on the true profile of the tradebook
- Automated cheapest-to-deliver identification: A collateral management solution determines which asset will be the cheapest to meet collateral and margin call obligations
- Automated collateral allocation and movement: An optimization algorithm goes beyond recommendations and automates booking and substitution processes to enable straight-through processing (STP)
- Automated portfolio and counterparty monitoring: The collateral management system continuously tracks thousands of metrics, identifying anomalies or unfavorable trends and notifying stakeholders accordingly
Optimization checklist
- Review current collateral management processes, identifying inefficiencies and areas of improvement based on the enterprise-wide opportunity cost profit and loss (PnL)
- Focus on the root causes of those inefficiencies
- Prioritize areas of improvement based on the opportunity cost PnL and a capability gap assessment
- Determine the necessary investment for each improvement case
- Set optimization objectives using the cases that will deliver the greatest efficiency boost
- Secure enterprise-wide buy-in
- Build a business case for investing in enhancing capability via a pilot project
Benefits
Additional revenue/reduced costs
Three cost-cutting improvements initiated by collateral optimization:
- Easier allocation of the cheapest-to-deliver assets to collateral outflows
- It mitigates the risk of over-collateralization and excessive liquidity buffers
- Collateral optimization technology enables the reduction of IT infrastructure and maintenance costs over time
Impact from a 1% increase in collateral efficiency
|
|
Large investment bank with collateral surplus |
Medium-sized retail bank with collateral deficit |
|
Under normal market conditions |
$1.2m additional revenue |
$1.1m reduced cost |
|
Under stressed market conditions |
$3.5m additional revenue |
$1.7m reduced cost |
Source: Deloitte “A balancing act. The collateral challenge for capital markets firms”
Improved capital efficiency
Maximizing collateral mobility and cost efficiency relies on having a real-time or near-real-time view of collateral across products and business lines to:
- Help managers identify funding opportunities and gain a more detailed insight into market changes
- Drive proactive counterparty credit-risk monitoring
- Provide the necessary data for routing trades to market participants and markets that deliver exceptional capital efficiency
Superior capital efficiency improves liquidity positions, increases the return on assets and reduces funding costs.
Additional competitive advantage
Besides competing on price, collateral optimization can help you implement straight-through processing in specific deals, improving the customer experience for all market participants.
Enhanced risk management
Structured and top-quality, organization-wide data on collateral allocation, status, cost and mobility allow the use of a wide range of analytics tools that can enhance risk management. These tools include multi-scenario forecasting, what-if modeling, stress testing and automated analytics that reduce the risk of human error.
Optimized collateral management provides greater insight into risk-weighted assets, as well as credit, market and operational risk exposures. A comprehensive overview also facilitates regulatory compliance (e.g., meeting margin requirements).
Challenges
Fragmented infrastructure
Financial institutions have multiple collateral management systems across asset types, jurisdictions and business lines. With such a fragmented infrastructure, viewing collateral data on an enterprise-wide level becomes a challenge, and leveraging analytics to identify specific capital inefficiencies and drive optimization could prove virtually impossible.
In addition, settlement and post-trade infrastructure might be fragmented, complicating fixing the optimal position for specific collateral usage.
Data availability and quality
Enabling data flows in a centralized solution is the key to efficient collateral management. Liberating data from those silos can be awkward due to:
- A lack of standardization: The data has to be standardized before it can be used for an enterprise-level consolidation so that it’s comparable
- Discrepancies in data: One data source presents one value in the entry, while another contains a different value. Which value can be trusted? To verify data accuracy, you must designate a single source of truth and outline reconciliation procedures for contradictory values
- Errors and delays: Data errors can block transaction processing and require manual intervention. Slow data exchange stretches out transaction processing as well
Manual-heavy, spread-out processes
Having multiple teams manage collateral allocation and optimization in largely manual workflows will likely leave insufficient data to drive efficiency improvements. In most cases, overreliance on manual processes fragmented across multiple teams means missed optimization opportunities and over-collateralization.
Misalignment in the definition of optimal
What’s your firm’s optimal level of collateral? Disagreement can lead teams to choose different optimization routes, leading to optimization and management inconsistencies.
Organizational silos
Optimization planning and implementation must include cross-disciplinary teams (business lines, desks, regions). You also need to collaborate with your legal, IT, compliance, risk management and treasury departments. As collateral management involves people in the back, middle and front offices, optimization should, too.
Performance monitoring
Choosing the right metrics to measure process efficiency is crucial. They might include collateral utilization ratio, funding cost reductions, liquidity coverage ratio, risk-adjusted return on capital, or return on assets. But remember, the metrics will be compared to past values, competitor performance and industry benchmarks.
The data from monitoring collateral management metrics should help continuously refine processes and infrastructure, finding what works and fixing what doesn’t.
Can you afford not to employ collateral optimization?
Inefficiencies in collateral management are becoming increasingly costly. Collateral inventory optimization is the perfect ally for controlling regulatory pressure, risk management and capital efficiency to generate additional revenue and reduce costs.
Find out more
To learn more about maximizing collateral management efficiency with the right combination of technology and operational changes, visit our website. Or, if you’d like an expert second opinion on your firm’s current strategy or want to discover how Luxoft’s collateral optimization enablement works in practice, contact us.
