Collateral Optimization as a Competitive Weapon

The business of collateral optimization has changed radically. In 2020, banks can no longer accept linear priority lists for collateral delivery because when viewed globally across balance sheets and product lines, this no longer makes sense. What was a cutting-edge solution even five years ago is now leaving money on the table. Automation is a central part of this change.

Automation of collateral optimization has shifted how solutions get implemented. While both vendors and institutions would always prefer one solution that provides turnkey results, it now requires far more than simply the ordering of collateral lists to deliver the outsized value seen in the past.

Optimization is an ongoing process that requires both sophisticated software and engaged stakeholders. In this article we discuss recent client lessons, including five key observations from clients on how institutions need to consider collateral optimization, and how our clients are approaching the next complex layer of global inventory optimization.

Client lessons on operationalizing the process

Collateral optimization requires a complex mix of people and technology. While automation is usually a desired end-state, there are an extensive number of processes, regulatory and client constraints that need to be incorporated first. In the past few months, Transcend has learned some important lessons working with clients:

  • Automation can outstrip human capacityCollateral recommendations from an automated optimization platform may produce more results than staff can handle. At one client, we found 400 recommended optimization moves a day. The head of collateral operations told us that 400 was an extreme amount given his team’s existing workload; 50 additional moves a day was more reasonable. As a result, we designed an output that maximized optimization for a customizable limit of 50 moves. This may not have captured the last penny but was operationally and financially optimal for the organization.
  • Timing and cutoffs matter. A holistic view of all inventory across the organization is best, however, a simple snapshot in time could mean that some assets are available in one region but not another. Firms will find themselves optimizing at multiple times throughout the day owing to cutoff times at clients, depending on region, and when market infrastructures like central securities depositories (CSDs) and central counterparties (CCPs) are open for business. It’s a necessity to have a real-time view of global inventory that is rich in contextual details such as “free and available to use”.
  • Advance preparation is essentialCollateral optimization may be practically or legally impossible on short notice due to collateral movement requirements. Systems must be in place to move collateral, whether a book entry or a cross-jurisdictional trade. Tools must be built in advance to net down legal entities or create a sequencing of moves that would otherwise be blocked by batches, manual limitations, legalities and timing cycles.
  • Optimize the optimizers. Third party service providers including tri-party, CCPs and CSDs want to optimize collateral for clients. This works for a client with all of their assets at one optimizer, but in practice, global organizations have a complex asset-liability footprint. As a result, some of our clients have begun to “optimize the optimizers”, taking control of the final result using their own tools. Since the client has the ultimate final visibility into all assets, only their comprehensive analysis can create a universal best outcome.
  • Fixed costs need to be considered. Linear programming works well with variable costs but can miss the fixed costs of collateral or custody movements that can turn an otherwise profitable collateral placement into a money-losing proposition or bad client experience. Fixed costs such as settlement can be difficult to model. What’s needed is a mixed-mode operating model that considers both fixed and variable costs.

These examples are the next iteration of collateral optimization, which recognizes the importance of both automation and also the realistic limitations of a human-centered process.

Global inventory optimization: the next big step

Aggregating inventory globally to a central data hub ensures that collateral optimization considers all available assets at any given times. It sounds easy but in practice contains substantial complexity, in particular the requirement that systems communicate with each other and that descriptive information about each asset is collected and accurate.

To date, collateral optimization has been a tactical and localized process. Individual business units have successfully delivered optimization for their region or silo but that has left the firm as a whole in the dark about where enterprise scalable opportunities may lie. Few firms have a holistic optimization strategy in place and fewer still have implemented one globally, but most recognize that tactical solutions have reached their limits. The next evolution of collateral optimization needs to occur to deliver on its promise of reduced costs and greater operational efficiency.

In an earlier article, Connected Data: The Opportunity for Collateral and Liquidity Optimization, I discussed the importance of connected data, or metadata, to global inventory management. This information covers: the tenor of a position; who the owner is; whether the position is owned by the firm or a client; rehypothecation status; and where it can be pledged at the lowest haircut. This enrichment process is still not conducted by most firms, resulting in real opportunity costs as assets aren’t fully optimized against the firm’s liabilities.

A global inventory optimization effort looks to solve for this problem by developing and assigning connected data to each asset. The process can be complex, but the end results deliver a level of collateral optimization that is robust and scalable. This is a cornerstone of broadening out the impact that optimization can have for financial services firms, starting from data and delivering through to actionable results.

Effective global inventory optimization is an input to solving an array of other problems, including:

  • Transfer pricing models
  • Scenario-based optimization
  • Increased automation
  • Regulatory reporting
  • Internal connectivity
  • Benefits to customers

Bringing optimization to the front office

Solving the problems of global inventory management and process automation while building tools for human/technology/process engagement is Transcend’s core business. The client examples discussed here show that collateral optimization works best with tools that are well thought-out in advance. We continue to work with our clients to explore where the boundaries lie in optimizing not just collateral but also the process.

Automation of collateral optimization can clearly be a competitive advantage. With hundreds of millions in revenue on the line, advanced firms are now looking to integrate pre- and post-trade across silos. Deciding whether to use collateral for a repo vs. deliver for an OTC derivatives transaction has been discussed since optimization has been around, and firms are now in a position to actualize this intelligence. Collateral optimization is not easy, but the promise of delivering meaningful results to the front office could unlock a new generation of technology development in the collateral space.

This article was originally published on Securities Finance Monitor.

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Centralized collateral management becoming a reality

Collateral management has transitioned from an ancillary service to a core competency, largely as a result of the sheer breadth of activity from front to back office and horizontally across silos and asset classes. This has spurred a marked shift towards centralization of collateral management, providing organizations with a centralized view of inventory as well as funding and collateral optimization decisions.

But the move to a more efficient and centralized model is not without challenges. Inefficiencies and the cost of errors are magnified by the multiplicity of internal and external relationships that need to be managed and the requirement to control positions more frequently, even in real-time.

This requires a fundamental shift from managing assets only for margin purposes to managing assets for value, cost and balance sheet purposes.

Moving to a centralized collateral organization is a difficult step for many reasons and as a result, some firms are decoupling their business organization from their technology capabilities.  They are instead focusing on building a centralized, horizontal technology strategy for inventory and collateral management.

In either case, the end goal may be the same – a holistic infrastructure that can yield the benefits of centralized collateral and inventory management coupled with sophisticated analytics and firm-wide optimization capabilities. Fortunately, today’s technology enables this ultimate goal as well as the smaller moves in this direction.

Steps to collateral optimization

Regardless of the approach taken, there are a number of best practices for firms looking to increase the efficiency of their collateral and liquidity management:

  1. Achieve visibility into inventory across multiple business lines and regions. This centralized view is extremely important.
  2. Ensure all collateral schedules and legal agreements are easily accessible as these will impose constraints on decision-making.
  3. Take a centralized view of different types of obligations and requirements to enable good decision-making.
  4. Establish targeted analytics and Key Performance Indicators (KPIs) to measure and monitor progress of these initiatives.

These are vital foundational steps towards achieving an optimized collateral management environment.

Connected data: The key to better decision-making

Of course, bringing the data together is just one part of the process – the next step is to connect the data so that algorithms and analytics can be applied to it. Firms understand that the information is there for them to make better decisions, but they face a challenge in getting useable information and putting it to work.

The main obstacle, in most cases, is that they have built their operational structures and technology around specific areas of the business. To achieve a view across the whole enterprise, these businesses require coordination and connectivity across a large number of different internal and external systems – not easy to accomplish.

The solution lies in implementing a system that is easy to integrate and is targeted at connecting and harmonizing this data.

Avoiding costly re-engineering

There are sometimes negative connotations around the phrase ‘legacy technology’ but this is not always accurate. A firm’s existing securities lending or repo or margin systems may be good, but they will more often than not have been built as separate systems. Rather than re-engineering all these systems, what the firm needs is a layer that pulls these disparate systems together to ensure they are seeing a holistic and harmonized view of inventory, positions and obligations.

Most firms have taken some steps to improve their inventory management, but there is a wide difference across the industry in terms of the strategies adopted to achieve this objective. Some organizations are trying to address the issue in a tactical way, fixing one system at a time to see whether this gives them greater visibility, but this approach does not have much longevity from a strategic perspective.

The larger organizations have usually taken a more strategic approach. Some see it as primarily an internal engineering effort, while others are talking to firms such as Transcend as they seek to harness real-time data, collateral and liquidity.

Regardless of the approach taken, being able to optimize collateral and liquidity decisions at an enterprise level has huge benefits. The sheer number of firms and analysts that have explored the scale of these benefits underlines the significance of the opportunity, and we find that most firms are actively taking steps towards achieving these capabilities.

Optimization models can be implemented with a rules-based approach or even using more sophisticated algorithms (i.e. linear and non-linear programming models). These all have a vital role to play in monetizing the connected data across the firm.

Scaling the benefits

Being able to optimize collateral across business lines is an obvious benefit, but there are also advantages to be gained from reducing internal errors and fail rates. In addition, funding costs will fall because firms will be managing their funding operations more efficiently: improving securitized funding leads to a reduction in more expensive, unsecured funding.

Whether or not firms embrace centralization across all aspects of their business, it is clear that rationalizing complex systems and harnessing fragmented data sets provides for informed, confident and compliant decision-making. And once centralized funding and collateral management are fully achieved, the benefits of efficiency, cost-savings and liquidity attain even greater scale for the firm.

This article was originally published on Global Investor Group.

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Collateral management: A path littered with obstacles

As collateral rules have grown in complexity, so has the need for greater optimization – But as Tim Steele [of Funds Europe] discovers, achieving that can be painful.

Collateral has long been used as a tool for mitigating counterparty risk and obtaining credit, but now more than ever, it is the key determinant of an institution’s ability to engage in financial transactions in the cash or derivatives markets….

“If you optimize every pool or silo individually, as a firm you will by design not be optimized,” says Bimal Kadikar.

Read the full article from Funds Europe

An interview with Bimal Kadikar, CEO of Transcend Street Solutions

“Transcend Street Solutions is establishing itself as an innovative player in the collateral and liquidity technology space. We spoke with CEO and founder Bimal Kadikar to learn more about what Transcend is doing and how it sees the evolving market.” – Josh Galper, Securities Finance Monitor

Read the full interview with Securities Finance Monitor