Why collateral optimization is critical

Since the global financial crisis regulators have aimed to reduce systemic risk and increase transparency by expanding the use of collateral—the exchange of cash or securities to mitigate default risk in financial transactions. Over-the-counter derivatives have begun moving into central clearingwhich requires collateral, and uncleared derivatives will need margin payments starting in September. Phil McCabe, global product manager for collateral at Bloomberg, said in a webinar in June that collateral optimization is now the concern of both the back and the front office as funding costs and collateral based discounting should be incorporated in pricing before a derivative is traded.

The regulatory environment

Bilateral derivatives have generally involved counterparties exchanging variation margin over the life of a trade. However, centrally cleared trades require both counterparties to pay both initial margin, in either cash or high-quality bonds, and exchange daily cash variation margin with a central counterparty. Starting June 21 2016, central clearing will be mandated for certain standard derivatives, which will lead to a large increase in collateral needs.

Regulators have also mandated collateralization of bilateral derivatives that are too complex to be centrally cleared such as inflation swaps. Starting September 2016, firms with balance sheets larger than €3 trillion will have to post both initial and daily variation margin on non-cleared derivatives. All other covered entities will have to post variation margin starting March of 2017, while the requirement to post initial margin will be phased by size on an annual basis until September 2020. McCabe said: “This is a big deal as firms who were managing collateral with manual processes, perhaps on spreadsheets, will struggle to move from posting on a monthly or weekly basis to daily.”

Regulation has therefore increased the amount of collateral that has to be posted, the number of counterparties required to post and the frequency of posting, increasing the need for collateral optimization.

Knowing your position

The key to collateral optimization is knowing the legal, derivative and collateral position. Firms need to accurately analyze the demand for collateral, the available supply and how to make the delivery as cheap as possible.

The derivative position and its change in price is needed to calculate how much collateral to post, the legal position details the eligible collateral that can be posted and collateral position is the assets that are available to be posted. An algorithm can determine how to optimize collateral based on the demand, supply, the cost of delivery and a firm’s internal requirements.

Cheapest to deliver

Counterparties have to agree in advance to trade on a collateralized basis and the legal agreement will detail eligible collateral and the exchange details. For example, eligible collateral could be cash or Greek government bonds in return for the overnight cash rate. Is it cheaper to just send cash or should you obtain Greek government bonds through a repo? The repo market facilitates collateral transformation as cash is lent in return for a bond at the repo rate, such as OIS plus 2 basis points. If the repo rate is higher than the overnight cash rate, as in this example, it makes economic sense to obtain Greek government bonds in a repo as collateral for the derivatives transaction.

In a large portfolio with many complex trades, and many choices in how to deliver collateral, it quickly becomes very difficult to calculate how to use collateral most efficiently.

Collateral transformation

After calculating how much collateral to  post, firms may find they do not have enough eligible assets. For example, an asset manager may have a large corporate bond portfolio but need cash collateral for a derivatives portfolio. The manager can use a repo to borrow cash using bonds as collateral. Alternatively, the manager may only be allowed to post government bonds and so could enter the stock lending market to borrow sovereign bonds in return for corporate bonds.

Collateral transformation options will lead to a range of prices which can be used to determine which collateral is most and least valuable so the least valuable assets are posted while the most desirable are kept. This has become increasingly difficult since the financial crisis and become an important factor in derivatives pricing.

Why collateral matters for derivatives pricing

One of the key factors in optimizing collateral is the cost of funding collateral. Before the financial crisis, balance sheets were largely funded on an overnight basis which did not cause an issue in liquid markets. However, post-crisis funding has become longer term and collateral becomes more expensive if funded at the three-month rate while returning only an overnight rate. As a result, every dollar of collateral causes a funding drag. The cost of this drag is difficult to calculate for long-term illiquid trades. A further complication is that the cost of funding the collateral posted as variation margin gives rise to the discount curve used to value a derivative, and, if a range of collateral is eligible to be posted, then there are several possible discount curves which makes valuation difficult. One method to overcome this difficulty is to build a discount curve from the term structure of the cheapest to deliver collateral across the life of a trade,.

Effective post-financial crisis collateral management has therefore become critical, not only in protecting against default, but also pricing trades and determining their economic viability. McCabe said: “The physical process of exchanging collateral has become more complex. There are more players, more is posted, more often and using more stringent criteria and this has led to the need to optimize the use of balance sheet.”

Collateral optimization is still in the early stages so first movers can gain an early advantage and reap rewards in an environment of low rates and decreasing returns on equity.