Why Firms Should Embrace Collateral Management Transformation Executive Summary

Why firms should embrace collateral management transformation Executive summary

The recent market stress, driven The current headwinds have should consider their ability to by the COVID-19 pandemic, has also impacted the rollout of new achieve appropriate economies of highlighted the importance of regulations. The Uncleared Margin scale and competitive advantage via developing and maintaining a Rules (UMR), which materially their existing collateral management cutting-edge collateral management impact initial and variation margin infrastructure and by leveraging capability, as it is essential to requirements, have seen a proposed automation and innovation effective monitoring and managing one-year delay for achieving techniques. Where firms cannot of credit risk exposure, identifying compliance for the remaining achieve appropriate cost benefits counterparty stress and enabling phases 5 and 6, enabling financial from upgrading and automating optimization of collateral inventories institutions to focus on maintaining existing capabilities, they should during periods of high market business continuity and effectively assess the opportunity to outsource volatility. While financial institutions managing risk. This delay provides their collateral management have shown noteworthy resilience, firms with an opportunity to functions. We expect that for many the recent heightened market strategically assess their options firms, particularly buy-side firms, volatility and margin call volumes for achieving regulatory compliance outsourcing will present an effective observed due to the COVID-19 and their broader collateral risk mitigating and cost-effective pandemic have exposed a significant management needs. solution. number of vulnerabilities in the To address the vulnerabilities collateral management operations, discussed in this article, firms should technology and data infrastructure assess their end-to-end collateral of institutions of all sizes on both the operating model across people, buy side and sell side. process, technology and data. Firms

1 | Why firms should embrace collateral management transformation 6x average margin call volumes across products

10x investigable margin disputes

Manual generation of management reporting at increased frequency

2 | Why firms should embrace collateral management transformation The current market environment prone manual intervention has driven a significant increase in across the transaction life cycle. Collateral volatility, resulting in volume spikes The volatile market conditions in secured funding transactions, have exposed the operational challenges collateral substitutions and limitations and financial risks of margin calls across the industry. relying on such a fragmented highlighted by These dynamics have been infrastructure. In margin compounded by downward management operations, the the COVID-19 pressure in asset valuations, volatility and volume have forcing firms to adjust their highlighted inefficiencies in pandemic funding and leverage strategies. data feed latency, margin Firms with fragmented collateral call processing, fragmented management infrastructure, and product-specific infrastructure, reliance on manual processes, have asset valuations, portfolio lacked the ability to effectively recon ciliations and dispute analyze, forecast, and manage management, and exposed their collateral inventory and governance challenges with obligations, resulting in missed stale client reference data and margin calls and suboptimal manual management and risk collateral allocations. reporting.

For many firms, collateral management processes lack automation and require continuous, inefficient and error-

The volatile market conditions “have exposed the operational limitations and financial risks of relying on such a fragmented infrastructure.

3 | Why firms should embrace collateral management transformation Figure 1: Collateral management life cycle

Onboarding Margin call management Portfolio valuations and reconciliations Legal negotiation Call calculation Collateral valuations

Agreement digitization Call issuance Portfolio valuations

Settlement instructions Call processing Portfolio reconciliations

Reference data Eligibility checks Dispute resolution

Client reporting

Subs management

Interest processing

Collateral optimization Collateral settlement Forecasting and reporting

Financing transactions Settlements Collateral forecasting

Portfolio optimization Payment controls Contingent liabilities

Sources and uses Reconciliations Regulatory reporting

Asset traceability Corporate actions Internal reporting

Cross-product margin Triparty

Pre-trade optimizer Segregation

4 | Why firms should embrace collateral management transformation Limited collateral analytics and optimization capability. their leverage and funding strategies, liquidating assets Increases in demand for collateral, coupled with downward to cover redemptions and manage against leverage limits. pressure on asset valuations, have highlighted the need for Increases in collateral demand, combined with limited robust collateral analytics and optimization capabilities. The insight into inventory, forced firms to allocate available, as fragmentation of collateral infrastructure across products opposed to optimal, assets to meet obligations. The use of and reliance on manual processes has exposed the lack of automated collateral analytics and optimization tools could timely enterprise-wide transparency required to effectively have otherwise significantly reduced funding costs and manage collateral inventory and forecast obligations. processing time during this period.

The need for robust collateral analytics and optimization tools was further emphasized when firms rapidly altered

Figure 2: Collateral management product scope

Margining activities Financing activities

OTC Futures Listed Cleared Mortgage Prime FMU Repo Securities Bank Securitized uncleared options swaps forwards broker custodial (bilateral and lending leverage loans derivatives buffers triparty) loans

5 | Why firms should embrace collateral management transformation Spike in margin call volumes. Firms margin thresholds or minimum margin call processing, compressed have reported experiencing up to transfer amounts. This has exposed timelines to agree to calls and a spike a sixfold increase in margin calls gaps with firms’ collateral account in the number of margin dispute across all products in a concentrated and agreement reference data, cases. period, creating pressure points including eligibility schedules, Increased settlement fails. on operations that heavily rely settlement instructions and contact With the increased transaction on manual processes that limit information. The lack of consistent, volumes, firms also experienced a scalability, increase control risks, accurate and complete data sets significant increase in settlement and the likelihood of operational requires additional downstream fails across both cash and securities. errors and processing delays. For investigation by collateral operations While partially explained by stale example, the majority of margin calls teams, delaying or reducing capacity settlement instructions and continue to be issued via email and to process all margin calls. communication challenges due to not through more efficient industry Position valuation complexities. remote working, the transaction utilities. This has created capacity The increased market volatility volumes exposed bottlenecks in pressure and, for some firms, led to introduced challenges in achieving the settlement processes and missed margin calls and avoidable accurate and timely asset valuations, infrastructure, as many firms still increases in counterparty credit risk specifically for complex derivatives, rely on manual wire/settlement exposure. financing and structured product approval processes, fax-based Many institutions that do have businesses. Collateral teams communications and manual collateral management systems tend generally rely on the trader marks web portal entries to facilitate to have fragmented infrastructure to value the positions, combined settlements. across products, increasing the with a monthly independent price Firms also lack the ability to difficulty to consolidate data for review process. In many instances, systemically monitor for settlement management and risk reporting, recent market turmoil negatively receipt and fails, relying instead monitor stressed counterparty watch impacted front office capacity to on reactive, manual processes. lists and provide intraday updates. value positions and obligations in a This limited transparency not only timely manner, resulting in delayed Incomplete, stale reference data. increases the operational burdens, delivery of complete transaction data Recent market volatility has also but also limits the transparency into feeds, valuations and initial margin triggered increased margin activity the collateral inventory and ability to requirements to collateral operations in previously dormant or inactive accurately forecast collateral sources teams for processing. Such delays accounts, causing breaches in and uses. caused downstream disruptions in

6 | Why firms should embrace collateral management transformation Figure 3: Margin dispute drivers

Key dispute drivers

Variation margin Initial margin

• Market value discrepancies • Sensitivity population • Missing/extra trades/novation incorrectly booked or missed • Sensitivity bucketing (i.e., trade alleged to wrong entity) • Missing/extra trades/novation incorrectly booked or missed • Booking methodology differences (i.e., trade alleged to wrong entity) • Snap timing discrepancy (i.e., FX rates) • IA percentage discrepancy • Cash flow differences (i.e., settlement/premium discrepancy) • CSA term discrepancy • Treatment of in-transit or failed collateral • Trade book not priced • Missing collateral movements • Collateral haircut discrepancy • CSA term discrepancy

The challenges observed through the pandemic across Spike in margin disputes and portfolio reconciliation the collateral life cycle are not new but were exposed by breaks. Due to differences in asset valuation methodologies the perfect storm of market volatility, margin call volume and process across counterparties, along with the prolonged increases and asset value fluctuation in a concentrated time market volatility, firms observed a spike in both volume and frame. It is important for firms to understand these challenges value of margin disputes, with some firms reporting a tenfold in relation to their existing end-to-end collateral operating increase in the number of high-value disputes requiring same- model, taking lessons learned to identify transformation day investigation. opportunities to enhance analytical capabilities and improve For most firms, dispute management investigation processes operational efficiency through process automation, system are highly reactive and manual, requiring consistent and consolidation and enhancement. timely communication between the counterparty, the trading For many firms, this may require an evaluation of their end- desk and middle-office teams. Initially, the remote working to-end collateral management technology stack to identify environment created communication challenges, requiring and consider where platform upgrades or consolidation could firms to proactively prioritize investigations and resulting in a accelerate achievement of desired collateral management backlog of dispute cases. capabilities. For others, consideration of the cost-benefit opportunities offered by outsourcing collateral management functions may serve as a more cost-effective solution.

7 | Why firms should embrace collateral management transformation The challenges observed “through the pandemic across the collateral life cycle are not new but were exposed by the perfect storm of market volatility, margin call volume increases and asset value fluctuation in a concentrated time frame.

8 | Why firms should embrace collateral management transformation 1. Transformation REVIEW YOUR OPERATIONAL opportunities OPERATING MODEL for collateral With the vulnerabilities exposed through the volume and volatility of the market through the pandemic, management and the upcoming increase in counterparties subject to the UMR rules, now is the time for firms to review their collateral operating model. For most firms, it has been nearly a decade since they reviewed their broad capabilities and operating model. The challenges experienced in the collateral management function highlight the need Today, there are several options available to firms to review and improve end-to-end collateral to enhance their capabilities and futureproof their processes, from front-office secured funding collateral management capabilities. Organizations can and financing activities through middle- and leverage the enhanced technology vendor platforms, back-office operational margin and settlement utilize disruptor technologies that have recently functions. The issues experienced during the entered the collateral management ecosystem or take pandemic demonstrated the importance of advantage of the rise of capabilities offered by asset collateral analytics, optimization capabilities, and service providers. the need for automated operational process and Regardless of being on the sell side or buy side, we workflow to effectively manage collateral. have identified several leading practice operating Firms should take this opportunity to strategically model principles that all collateral management review their existing operating model and identify operations groups should enact in defining their target the many opportunities for improvement. Firms operating model: should invest in their front-office trading and • Consolidate enterprise-wide collateral inventory and optimization infrastructure and review whether optimization analytics they should invest in further uplifting operational capabilities in-house or outsource these functions • Implement single-product-agnostic margin call to an asset service provider. management workflow

There is not a one-size-fits-all model to improve • Maximize the use of collateral ecosystem utilities to collateral management capabilities, and we drive automation encourage firms to strategically assess their • Implement a proactive approach to identification and options in context of their existing infrastructure, resolution of margin call disputes process scalability, resiliency and business objectives. Significant control, cost and • Independently calculate and validate initial margin financial resource efficiency has been observed requirements (UMR, central counterparty clearing through investment in front-to-back collateral house, prime broker, independent amount, etc.) transformation programs. • Automate collateral settlement monitoring process to proactively identify settlement fails

• Integrate and automate generation of stakeholder analytics and reporting into workflow

• Enable infrastructure to support intraday margin call processing

9 | Why firms should embrace collateral management transformation For firms focused on “connecting the front- to-back infrastructure, there are solutions that can serve front- office, trading and optimization, and operational needs.

10 | Why firms should embrace collateral management transformation Figure 4: Collateral management operating model options

Asset servicer technology Outsource to asset In-house analytics and External vendor solution as part of broader servicing/agency financing optimization infrastructure technology solution with relationship with in-house business providing with in-house trading team in-house trading team trading team optimization, agency financing and collateral transformation, and triparty service

optimization Dealers and largest buy- Buy-side firms looking to Buy-side firms with limited Largest dealers with side firms with multi-asset- close targeted capability current capability or scale Front office analytics and analytics office Front existing base capabilities class diverse portfolio gaps for in-house ROI

In-house/captiveIn-house/captive OutsourceOutsource Operating model

In-house operations team and In-house operations team Full outsourcing of operations and internally developed core margin leveraging external vendor technology needs associated with operations system technology platform margin to asset servicing provider Margin operations Margin Limited to largest dealers with Dealers and select large Regional dealers and buy-side firms legacy in-house-built capabilities buy-side firms of all sizes

11 | Why firms should embrace collateral management transformation 1.1 1.2 SELL-SIDE OPERATING MODEL BUY-SIDE OPERATING MODEL CONSIDERATIONS CONSIDERATIONS

For the sell side, many firms’ infrastructure and Most of the buy-side firms’ collateral management supporting teams continue to be siloed by product, capabilities are highly fragmented and manual. There has limiting the ability to achieve economies of scale, been a lack of investment in infrastructure with many consolidate timely counterparty exposure reporting firms continuing to rely on spreadsheets to support their and effectively implement watch list processes. We collateral processes. With the regulatory environment have observed how fragmented operating models shifting with UMR due to take effect over the next two supported by end-user computing solutions limit firms’ years, a spreadsheet-based process will no longer be viable abilities to create a true exception-based process and to handle the added complexity or increased volume. inhibit firms from maximizing the use of the industry The operational risk of relying on manual processes was utilities across product. exposed through the pandemic with the spike in volumes leading to missed calls, fails and lack of transparency into It is critical that sell-side firms develop a product- the status of settled collateral and margin calls. agnostic, exception-based management workflow solution to maximize efficiency globally. For the There is a significant opportunity to drive efficiency through largest sell-side firms, an integrated collateral implementation of collateral management infrastructure infrastructure will likely be achieved by a technology that meets industry standards. Firms need to consider solution, either in-house or through one of the whether they should invest in buying the technology and industrialized technology providers of enterprise upskilling the captive teams to support the evolution of collateral management solutions. It has been observed the industry or whether they should look to asset servicing that there are several automation opportunities outsourcers to meet this need. There is a compelling across the collateral life cycle that can be leveraged argument for both approaches, and firms should consider to augment existing processes and overcome existing how integrated their infrastructure can and needs to be inefficiencies, which can lead to a lower investment to from the front office to operations. realize a significant efficiency for the largest dealer For firms focused on connecting the front-to-back firms. infrastructure, there are solutions that can serve front- For the medium-sized and smaller dealer community, office, trading and optimization, and operational needs. the option of leveraging an outsource solution from For firms that adopt this integrated approach, there is an asset servicer should be seriously considered and a compelling argument for buying a consolidated and weighed against the operating cost of a technology comprehensive technology solution. However, for most platform and a captive team. We believe as the asset firms that are solely looking for collateral operations servicers achieve greater scale there is likely to be capabilities, there is a compelling economic and control a compelling business case for some of the sell side opportunity for outsourcing collateral services to asset to further explore this option. Firms should ensure servicers, with many servicers also providing front-office that there is clear integration between their front- solutions such as analytics and optimization capabilities as office optimization needs and supporting operational part of the package. infrastructure when determining the appropriate When reviewing the operating model, firms should look to operating model. develop a detailed business case that considers more than just the cost components of each model. Firms should also consider the need to future proof the capabilities and the likely investment in continual upgrades and improvements, the regulatory outlook, the product mix covered, the benefits of internal control, risk management factors, the ability to connect to the broader collateral ecosystem and the counterparty experience that each model delivers.

12 | Why firms should embrace collateral management transformation 2.

COLLATERAL ANALYTICS AND achieved. On the pledge side, the tools can identify the optimal assets to meet collateral requirements based on OPTIMIZATION built-in constraints, including available inventory, eligibility and obligation type. When considering operating model transformation opportunities, firms should emphasize the The development of an optimization engine can enable development of transparency and analytical real-time automated solutions that eliminate the human capabilities to enhance collateral optimization. element in the decision-making, driving significant Firms can build a foundation for broader analytics operational and financial resource efficiency. During times by developing a cross-product, real-time view of of market volatility and stress, the solutions can further their available enterprise inventory, obligations assist in managing inventory and obligations effectively. and eligibility. Intraday analytics help collateral Firms should consider their build, buy and outsource and funding managers identify opportunities, but options in relation to optimization capabilities and also provide insight into new obligations as the supporting infrastructure. Building optimization market moves. Such analytics can be leveraged to capabilities requires significant investments for drive proactive counterparty credit risk monitoring integration of front-to-back infrastructure across in support of watch list and default management products, data connectivity and automated algorithms. protocols. Sell-side firms with mature and complex technology More advanced firms should consider developing stacks should consider in-house build efforts required a comprehensive collateral optimization toolkit to against the capabilities and costs of a vendor solution assist in optimizing both the obligation and the to support optimization. For buy-side firms that may collateral pledge across funding activities (bilateral lack comprehensive infrastructure, a choice between and repo) and margin needs (derivatives, initial technology vendors and outsourcing to an asset service margin, etc.). Collateral optimization can help provider presents compelling options to drive significant firms minimize obligations by routing trades to efficiency in the use of collateral. counterparties and markets where efficiency can be

13 | Why firms should embrace collateral management transformation 3.

INCREASE THROUGHPUT OF • Connecting financing and segregation services solutions are evolving to automate the optimization and collateral INDUSTRY UTILITIES upgrade/downgrade capabilities that will drive industry efficiency and likely commoditize optimization solutions. As part of a strategic collateral management We also expect to see an increasing adoption of transformation, institutions should maximize usage sponsored, agency and peer-to-peer market financing of established industry utilities. The migration to a services improving market liquidity and collateral systemic solution will help reduce manual processes, mobilization. however, leveraging collateral industry utilities will enable significant cost and time efficiency. The • Trade affirmation platforms will enable trade confirmation utilities will need to upgrade their functionality to and affirmation at point of trade to ensure matching of industrialize the support of non-over-the-counter transaction data supporting the minimization of trade (OTC) bilateral derivatives and become product disputes. agnostic. • Valuation services have an increasing presence to • Vendors such as AcadiaSoft and triResolve provide services as an independent valuation agent for increasing the volume of non-OTC bilateral transactions, further reducing the risk of valuation-driven derivative margin calls through the services will disputes and eliminating a complex and time-sensitive provide significant benefit across the buy and sell internal process. sides, although full realization of the benefits will require support across the industry.

• Triparty adoption for collateral movements and segregation across a broader product set and a wider adoption of the ability to re-hypothecate triparty assets will drive greater optimization efficiency and enhance asset mobility.

14 | Why firms should embrace collateral management transformation 4. 5. ENABLE PROACTIVE DISPUTE AUTOMATED MANAGEMENT SETTLEMENT FUNCTIONALITY

Margin disputes spiked across the street through the AND INFRASTRUCTURE pandemic. The disputes were driven due to missing CONNECTIVITY transactions, valuation differences and collateral balance issues. Firms need to focus on resolving Firms, specifically on the buy side, continue to rely on upstream data challenges to enhance the resiliency manually entered payment and settlement instructions and efficiency of the collateral management process. and settlement monitoring. This presents challenges in Opportunities for enhancement that should be delivering operational efficiency, optimization capabilities considered include the following: and effective risk management. When firms consider their operating model, ensuring an end-to-end approach • Digitize block trade allocation processes and is adopted will require them to consider the scalability of leverage artificial intelligence for proactive their settlement processes. Specific opportunities that validation firms need to address include the following: • Digitize confirmation and affirmation process • Develop connectivity with settlement infrastructure workflow to automatically capture attributes leveraging SWIFT or SWIFT-like messaging and systemically supporting workflow to eliminate manual paper-based • Review data strategy and critical path feed timing wire processes, enhancing resiliency and control to ensure timeliness of data feeds • Establish an automated and predictive fails process to • Review valuation approach and automate where monitor inbound and outbound settlements for potential possible through data services to remove reliance challenges and fails to move to a proactive T0 control and delay from manual front-office pricing from a reactive T+1 or longer reconciliation

• Digitize margin agreements to ensure data For each firm, the operating model that best suits its attributes are accurately captured and systemically needs is available. With advancing innovation, the number reviewed of providers in the market and increasing complexity of the process, it can be challenging to find the best Firms that can address their upstream data fit. A pragmatic and rapid business case and target challenges should then look to move to proactive operating model analysis is a must as firms future proof and systemic dispute identification and resolution, their organization to learn from the pandemic and meet moving away from the current highly reactive regulatory expectations. processes. Firms can leverage the emerging automation technologies to automate the dispute process. Proactive identification looks for historical patterns and previous day disputes prior to margin call issuances. Benefits of proactive identification include the ability to prioritize investigations by systemically removing false positive and reoccurring disputes in order to prioritize high-risk issues and other higher-value tasks.

15 | Why firms should embrace collateral management transformation Firms need to focus on resolving “upstream data challenges to enhance the resiliency and efficiency of the collateral management process.

16 | Why firms should embrace collateral management transformation A final word

The unprecedented volumes and market volatility complex task. It is our hypothesis that as firms review their resulting from the COVID-19 pandemic have exposed operating model and look to the future design, there will be process gaps and inefficiencies across the collateral an increase in the adoption of services provided by asset management life cycle. Although many of these servicing firms, especially for the buy side, with the services challenges were known, the issues were exacerbated value chain provided by the asset servicers moving upstream and the need to remediate more prevalently exposed. to meet and enable front-office needs.

As firms assess their capabilities and review their We encourage firms to leverage the vulnerabilities exposed target operating model to decide on a build/buy/ by the pandemic, the upcoming regulatory reform that outsource model or optimize through automation, will increase volume and complexity, and the need to drive it is imperative that they consider the front-to-back financial resource efficiency to perform a holistic and collateral management life cycle, from the front- thorough review of end-to-end collateral management office needs related to analytics and optimization to capabilities and design a target operating model that meets the operational needs for process standardization, their evolving future needs. efficiency and control.

The increasing complexity of the operating model options and the need to drive operational and financial resource efficiency make the definition of the business case and design of the target operating model a

17 | Why firms should embrace collateral management transformation Contacts

John Boyle Contributions by Senior Manager Brendan Winkler Ernst & Young LLP Managing Director +1 212 773 5412 Ernst & Young LLP [email protected] +1 512 473 1601 [email protected]

Mark Nichols Jan Rosam Senior Manager Partner Ernst & Young LLP EY GmbH WPG +1 212 773 2701 +49 6196 996 21311 [email protected] [email protected]

Christian Rump Erica Becker Senior Manager Manager EY GmbH WPG Ernst & Young LLP +49 6196 996 21364 +1 212 773 9443 [email protected] [email protected]

David Williams Partner Ernst & Young LLP Jimmy Ryan +44 20 7951 4893 Manager [email protected] Ernst & Young LLP +1 212 773 3850 [email protected] Sky So Partner Ernst & Young Advisory Services Limited +852 28499217 [email protected]

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