An Interview with Bimal Kadikar of Transcend
RMA Global Markets and Securities Lending Director Fran Garritt recently interviewed Bimal Kadikar, founder and CEO of the collateral-focused technology firm Transcend, on current issues in collateral management, including the growing demand for high-quality collateral and the recent implementation of the Qualified Financial Contracts (QFC) reporting rules. Their Q&A follows.
This interview originally appeared in the February 2020 issue of The RMA Journal, copyright 2020 by The Risk Management Association. Read or download the PDF, here.
GARRITT: To start off, can you explain how collateral is used in securities finance?
KADIKAR: In the broadest sense, when firms execute bilateral or multiparty transactions, collateral is what backs the risk of a trade. It acts in the way a house or a car would in a mortgage or auto loan. Securities or cash are made available to secure financial transactions such as the financing of repurchase (repo) contracts. Collateral is needed to protect against any deterioration in market value or the credit quality of a counterparty. In the case of derivatives transactions, collateral is about de-risking. In the context of repo or pure funding it’s about being able to raise cash in a secure market. Collateral is sometimes too broadly defined or ill-defined because it means different things based on who you talk to.
GARRITT: What are the key structural issues firms face now regarding collateral management?
KADIKAR: Since the credit crisis, regulators have been focused on de-risking and reducing systemic risk. A key factor is safeguarding bilateral trades. Regulators have taken one of two approaches in that area. One, they are trying to force transactions through clearing channels like central clearing on exchange-traded instruments. If a trade has to be bilateral, there is emphasis on posting the proper quantity and quality of collateral to ensure that even if there is a big negative impact on one counterparty, the financial system is stable. As a result, collateral demand is generally increasing. Meanwhile, regulators have also made changes to improve the liquidity of the big players, who now must hold more high-quality collateral on their books. The demand for high-quality collateral has increased, and the supply is lower. Firms need to figure out how to navigate this.
GARRITT: How would you define collateral optimization?
KADIKAR: Optimization means creating a process which can drive increased efficiency and financial performance. For example, if you are a margin specialist and you have a decision to make about which collateral to deliver against a specific triparty trade or margin call, optimization could mean making sure you are allocating the cheapest-to-deliver securities. Or you could be sitting on a securities lending desk and thinking about how to allocate borrows or loans to minimize the capital that has to be held against the counterparty’s books. Or you could be on a derivatives or futures desk, deciding which exchange to send cleared trades to so that margin requirements are reduced. Optimization will mean different things to different people. It boils down to having a framework that can incorporate the various factors and costs that drive that performance requirement. The various costs could be liquidity coverage ratio (LCR), jurisdictional, credit, etc. Being able to incorporate those costs harmoniously is what optimization is. It clearly is not a “one size fits all.”
Firms need to address this in a holistic manner. Often, the various business lines—securities lending, repo, derivatives—have their own platforms and systems. Creating a holistic view or capability to optimize across businesses is a challenge. Firms are in different stages of figuring out how to go about it. One challenge is there are too many businesses or silos that are either producers, consumers, or both of collateral.
GARRITT: Besides standard clearing and increased collateral requirements, what are some of the more challenging regulations firms are addressing?
KADIKAR: The Securities Financing Transaction Regulation (SFTR), the Markets in Financial Instruments Directive (MiFID II), and, more importantly, the Qualified Financial Contracts (QFC) rules require firms to be able to apply their trades to collateral, agreements, and guarantees and then report to regulators on transaction date-plus-one basis. These are fairly complicated requirements. Firms need a comprehensive ability that cuts across business silos and different functions to be able to produce that information. Regulators are moving past writing and designing rules and getting more into the enforcement and analysis phase. They are determining how well firms are complying with the rules that have been created over the past 10 years, a majority of which are under the umbrella of the resolution planning set of rules and regard the capability firms must have.
GARRITT: What impact do the net stable funding ratio (NSFR), the aforementioned liquidity coverage ratio (LCR), and high-quality liquid assets (HQLA) rules have on collateral management?
KADIKAR: All these regulations are driving liquidity standards and the capability of firms in this space. Firms not only need high-quality assets on the books, they also need the ability to consider the liquidity buffer. Firms need a specific understanding of the sources and uses of collateral, because how it is raised and used determines whether it pertains to the numerator or denominator of the LCR or NSFR. If you don’t have the ability to connect the right dots in how you put together your sources-and-uses model, you will be penalized in how your LCR is calculated. As a result, your profitability will be impacted.
There has been a bespoke approach to how firms have chosen to operationalize the implementation of the rules. There are cases where, say, a firm’s treasury department may have been tasked with calculating LCR. In most cases that framework has not been at an enterprise level. Often there are businesses in a firm that are blind to or vaguely aware of how their activity is impacting the subsequent calculations that result once you look at operations from an LCR or HQLA basis. There has been a rough adoption of these rules in firms, which is causing friction. The impact of these rules often gets overlooked when you think about them from a measuring and operationalizing perspective.
GARRITT: What is the impact of recovery and resolution planning regulation (RRP) on the collateral business?
KADIKAR: Regulators are mandating that firms need a certain level of capability and knowledge regarding collateral. During the financial crisis, counterparty collateral at Lehman was a big issue. Regulations require every firm to know not only what collateral they have but the counterparty collateral they are holding and its jurisdiction. They must have the capability to know that information on a T-plus-one, early in the morning basis—and on an enterprise level. There are other requirements regarding payments and visibility into intraday liquidity. Firms need to know all the payment and clearing requirements, and how they would operate in normal and stress scenarios.
GARRITT: You mentioned QFC Recordkeeping. Tell me a little more about that.
KADIKAR: The main requirement is firms need to track in a detailed manner all contracts that are defined as qualified financial contracts. This includes tracking all derivatives, repos, margin lending, and prime activities, including trades that are in nonstandard settlement cycles. It also includes all the collateral that has been posted or received against those transactions, all the guarantees that may be in place by any party or counterparty, and the ability to create netting sets and then provide output defined by the regulators in eight sets of tables. It’s not just transaction data. It’s transaction data aligned with referential data from a counterparty and principal perspective, including who is the right contact for these things. Firms need to do this on a T-plus-one, 7 a.m. Eastern time basis.
The first step is figuring out where the relevant QFC positions are. The second challenge is reporting on agreements. More than 20 terms of an agreement are reportable under QFC recordkeeping rules. This is daunting, especially for many firms that have challenges in accessing terms of agreements in a digital form. While many firms have this information digitally, not all do. And even for firms that have agreements in digital form, systems that book trades often do not refer to agreement IDs, which would tie positions to agreements in a seamless manner. Further, QFC recordkeeping is not just a matter of reporting on the counterparty and principal. There are many other aspects, especially in complicated scenarios like when there are multiple legal entities on the counterparty side. And that has to be provided not only for the position but for the collateral. You need to overlay the reference data and make sure it is available in a linked manner. Getting clean data for reference purposes is also a big challenge—even simple data points like the right contact person or city. Regulators have specific requirements regarding the format they want information in. If you do not have it that way, you may be faced with a big cleanup or mapping exercise.
Once you figure out the reporting, you must ensure you can reproduce it on a on a day-to-day basis. You need a dashboard to see how you are doing regarding compliance and to identify problems—and who needs to fix them—on an ongoing basis.
The idea behind the recordkeeping is if the Federal Reserve or Federal Deposit Insurance Corporation has to liquidate a failing institution they need a good set of information to make decisions on contracts. QFC recordkeeping provides a consolidated set of information to make quick and quality decisions in a stress event.
GARRITT: Which firms have to comply?
KADIKAR: Six firms were set to be in scope by the end of 2019. Up to roughly 30 overall will likely need to comply by 2021. The scope is determined by size and complexity. Due to the quickly approaching compliance dates, there has recently been a significant increase in focus on QFC-related requirements by the remaining in-scope firms. This was particularly evident at the RMA-EY hosted roundtable that took place in November. Firms are addressing challenges including how to strategically digitize a diverse set of legal agreements, how to link QFC data across disparate data centers and attributes, how should exemption monitoring be handled, and asking questions like how to run a QFC Recordkeeping program in BAU mode.
GARRITT: What final advice would you have for firms as they work to comply with QFC and other recordkeeping regulations?
KADIKAR: Implement systems in a way that it is sure to drive business value. This is a huge challenge for the industry. Institutions are investing billions of dollars into regulatory initiatives. They must ensure they can capture a business benefit from all of this data, and must think about this as they are designing solutions.
GARRITT: What sorts of benefits?
KADIKAR: There are significant advantages to having the right data in the right form regarding decisions for placing collateral and funding opportunities. Counterparty credit issues can also be addressed with a connected data set. And there are other stakeholders who have emerged who are looking to benefit from this information, whether it is liquidity risk reporting requirements or enterprise credit looking for better data regarding the overall ecosystem. If you do things properly and in a way that creates a connected data ecosystem to make decisions in real-time, or at minimum at an end-of-day or start-of-day basis, you can use the same infrastructure for other regulations as they come along.