To combat inflation and a potential overheating economy, the Federal Reserve has begun communicating plans to aggressively raise interest rates throughout 2022 and 2023. The Fed began with a modest increase of .25%, however market professionals are estimating as many as six additional rate increases in 2022 to move monetary policy toward a more neutral rate environment. Similar interest rate increases have occurred in other industrialized economies as inflation continues to grow globally. Market participants are now increasingly looking for new financing and trading efficiencies to get ahead of additional funding costs and the risk of stunting profitability and growth. While collateral optimization has always helped minimize funding and liquidity costs, the new rate environment is creating even greater urgency for optimization to drive P&L benefits.
The Impact on Financing Collateral
The first impact of potential changes in the rate environment are increases in absolute interest rates and the overall costs to finance collateral. Simply put, the cost of borrowing cash will be more expensive than it’s been in years and will increase the overall costs to support certain trading and customer financing strategies. Banks and broker dealers have enjoyed a period of relative calm for balance sheets; however, as central banks step away from asset purchases, there will be new supply that needs to be financed in the market. As a result, firms that are inefficiently utilizing their collateral and unsecured funding risk impacting their P&L.
In addition to increases in absolute rates, the new environment can mean it will be more costly to support long-term funding and financing lower-quality collateral. While there are various projections for future funding costs as a result of rate increases, the premia for longer term funding could increase over time. Additionally, funding spreads for lower quality collateral could increase and create a more punitive environment for financing non-government collateral. Volatility of certain asset classes, including corporate bonds, may act as an accelerant for credit spread widening. These potential changes to term premia and spreads would impact certain portfolios and trading strategies, impacting the funding costs and P&L of those businesses.
Finally, rising interest rates can also influence firms’ risk tolerance and subsequently their investment choices, ultimately causing certain sources of funding to be less attractive, less stable and harder to manage.
An Opportunity for Optimization
With increasing absolute rates, spreads and term premia, the cost of financing businesses is set to be higher and more volatile. The goal of an effective collateral optimization strategy is to help market participants extract the greatest value from their financial resources; as such, there is a large opportunity for collateral optimization to maintain and increase profitability. By evaluating the costs of financing various collateral types with differing qualities, an optimization strategy will help firms more strategically select the collateral that meets a counterparty’s eligibility requirements while minimizing liquidity and funding costs to the business. With higher costs to consider, the potential savings from a collateral optimization strategy will materially increase.
Optimization Potential in Practice
Transcend has seen firms realize significant benefits from implementing collateral optimization across their financing and margining activity. By strategically implementing end-to-end solutions that incorporate funding /capital costs, collateral eligibility and operational costs into their optimization solutions, firms have been able to automate the allocation of preferred collateral to these exposures and obtain millions in annualized saving across financial, efficiency and risk factors.
In an environment of increasing absolute rates, wider spreads and higher costs of unsecured funding, these firms are poised for even greater cost savings. Transcend’s research and analysis team found that based on conservative rate assumptions, potential savings from optimization could increase an additional 16% to 250%.
The Importance of Technology
The value of being able to optimize vertically or horizontally across collateral silos under new a rate environment is clear. However, achieving collateral optimization can be difficult without the right partners and tools. While developing a cross-product collateral optimization solution in house can take several years, market participants need to implement an optimization solution now before rate increases impact profitability. As a result, more firms are looking to partner with companies like Transcend to more quickly mitigate the impact of a new rate environment.
However, not all optimization solutions are the same. With a holistic optimization platform built on enterprise inventory that considers multiple cost dimensions, market participants can more effectively understand and improve the utilization of collateral in totality, thus limiting unnecessary financing and liquidity costs. A single optimization solution for all asset classes, tri-party providers, and margin needs will deliver significantly higher returns, and ultimately will be a firm’s competitive financial edge. However, scalability is also crucial to ensuring both the immediate and long-term value of optimization results. By leveraging technology that can optimize decisions within a specific product or business-line first, with the opportunity to expand to multiple divisions over time, clients can realize a quicker time to value without limiting future potential.
Lastly, an effective optimization solution should enable straight-through-processing. Delivering the collateral that maximizes cost reduction could require complex collateral mobilization activities. As a result, any optimization solution needs to be able to automate and seamlessly execute movement recommendations in order to limit operational friction and roadblocks.
The market evolution is creating real urgency for firms who have not yet invested in collateral optimization to implement tried-and-true solutions and stay ahead of the impact of incremental rate increases. Similar feedback from market participants has revealed the importance of solutions that can automatically adapt to fast-changing environments.
With a history of successes deploying cross-product and cross-business optimization solutions at some of the industry’s largest banks and broker dealers, Transcend is the solution of choice to address the urgent optimization requirements under the new rate environment. Transcend’s holistic data framework and powerful, yet configurable, optimization algorithm ensures that clients can achieve the greatest optimization results today, while scaling to address rate and market evolution in the future. With an integrated booking service, Transcend ensures it’s clients can execute their optimization strategy both quickly and efficiently.
With a team of 140+ seasoned industry professionals possessing decades of hands-on capital markets and technology expertise, Transcend partners with clients to design an implementation strategy that delivers results in months, not years. This means, new clients can achieve tangible optimization benefits before interest rates severely impact their firm’s growth and profitability.
This article was originally published in the Securities Finance Times Technology Annual 2022
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