1.1 Sell-side operating model considerations
For the sell side, many firms’ infrastructure and supporting teams continue to be siloed by product, limiting the ability to achieve economies of scale, consolidate timely counterparty exposure reporting and effectively implement watch list processes. We have observed how fragmented operating models supported by end-user computing solutions limit firms’ abilities to create a true exception-based process and inhibit firms from maximizing the use of the industry utilities across product.
It is critical that sell-side firms develop a product-agnostic, exception-based management workflow solution to maximize efficiency globally. For the largest sell-side firms, an integrated collateral infrastructure will likely be achieved by a technology solution, either in-house or through one of the industrialized technology providers of enterprise collateral management solutions. It has been observed that there are several automation opportunities across the collateral life cycle that can be leveraged to augment existing processes and overcome existing inefficiencies, which can lead to a lower investment to realize a significant efficiency for the largest dealer firms.
For the medium-sized and smaller dealer community, the option of leveraging an outsource solution from an asset servicer should be seriously considered and weighed against the operating cost of a technology platform and a captive team. We believe as the asset servicers achieve greater scale there is likely to be a compelling business case for some of the sell side to further explore this option. Firms should ensure that there is clear integration between their front-office optimization needs and supporting operational infrastructure when determining the appropriate operating model.
1.2 Buy-side operating model considerations
Most of the buy-side firms’ collateral management capabilities are highly fragmented and manual. There has been a lack of investment in infrastructure with many firms continuing to rely on spreadsheets to support their collateral processes. With the regulatory environment shifting with UMR due to take effect over the next two years, a spreadsheet-based process will no longer be viable to handle the added complexity or increased volume. The operational risk of relying on manual processes was exposed through the pandemic with the spike in volumes leading to missed calls, fails and lack of transparency into the status of settled collateral and margin calls.
There is a significant opportunity to drive efficiency through implementation of collateral management infrastructure that meets industry standards. Firms need to consider whether they should invest in buying the technology and upskilling the captive teams to support the evolution of the industry or whether they should look to asset servicing outsourcers to meet this need. There is a compelling argument for both approaches, and firms should consider how integrated their infrastructure can and needs to be from the front office to operations.
For firms focused on connecting the front-to-back infrastructure, there are solutions that can serve front-office, trading and optimization, and operational needs. For firms that adopt this integrated approach, there is a compelling argument for buying a consolidated and comprehensive technology solution. However, for most firms that are solely looking for collateral operations capabilities, there is a compelling economic and control opportunity for outsourcing collateral services to asset servicers, with many servicers also providing front-office solutions such as analytics and optimization capabilities as part of the package.
When reviewing the operating model, firms should look to 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.
2. Collateral analytics and optimization
When considering operating model transformation opportunities, firms should emphasize the development of transparency and analytical capabilities to enhance collateral optimization. Firms can build a foundation for broader analytics by developing a cross-product, real-time view of their available enterprise inventory, obligations and eligibility. Intraday analytics help collateral and funding managers identify opportunities, but also provide insight into new obligations as the market moves. Such analytics can be leveraged to drive proactive counterparty credit risk monitoring in support of watch list and default management protocols.
More advanced firms should consider developing a comprehensive collateral optimization toolkit to assist in optimizing both the obligation and the collateral pledge across funding activities (bilateral and repo) and margin needs (derivatives, initial margin, etc.). Collateral optimization can help firms minimize obligations by routing trades to counterparties and markets where efficiency can be achieved. On the pledge side, the tools can identify the optimal assets to meet collateral requirements based on built-in constraints, including available inventory, eligibility and obligation type.
The development of an optimization engine can enable real-time automated solutions that eliminate the human element in the decision-making, driving significant operational and financial resource efficiency. During times of market volatility and stress, the solutions can further assist in managing inventory and obligations effectively.
Firms should consider their build, buy and outsource options in relation to optimization capabilities and supporting infrastructure. Building optimization capabilities requires significant investments for integration of front-to-back infrastructure across products, data connectivity and automated algorithms. Sell-side firms with mature and complex technology stacks should consider in-house build efforts required against the capabilities and costs of a vendor solution to support optimization. For buy-side firms that may lack comprehensive infrastructure, a choice between technology vendors and outsourcing to an asset service provider presents compelling options to drive significant efficiency in the use of collateral.
3. Increase throughput of industry utilities
- As part of a strategic collateral management transformation, institutions should maximize usage of established industry utilities. The migration to a systemic solution will help reduce manual processes, however, leveraging collateral industry utilities will enable significant cost and time efficiency. The utilities will need to upgrade their functionality to industrialize the support of non-over-the-counter (OTC) bilateral derivatives and become product agnostic
- Vendors such as AcadiaSoft and triResolve increasing the volume of non-OTC bilateral derivative margin calls through the services will provide significant benefit across the buy and sell 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
- Connecting financing and segregation services solutions are evolving to automate the optimization and collateral upgrade/downgrade capabilities that will drive industry efficiency and likely commoditize optimization solutions. We also expect to see an increasing adoption of sponsored, agency and peer-to-peer market financing services improving market liquidity and collateral mobilization
- Trade affirmation platforms will enable trade confirmation and affirmation at point of trade to ensure matching of transaction data supporting the minimization of trade disputes
- Valuation services have an increasing presence to provide services as an independent valuation agent for transactions, further reducing the risk of valuation-driven disputes and eliminating a complex and time-sensitive internal process
4. Enable proactive dispute management
Margin disputes spiked across the street through the pandemic. The disputes were driven due to missing transactions, valuation differences and collateral balance issues. Firms need to focus on resolving upstream data challenges to enhance the resiliency and efficiency of the collateral management process. Opportunities for enhancement that should be considered include the following:
- Digitize block trade allocation processes and leverage artificial intelligence for proactive validation
- Digitize confirmation and affirmation process workflow to automatically capture attributes systemically
- Review data strategy and critical path feed timing to ensure timeliness of data feeds
- Review valuation approach and automate where possible through data services to remove reliance and delay from manual front-office pricing
- Digitize margin agreements to ensure data attributes are accurately captured and systemically reviewed
Firms that can address their upstream data challenges should then look to move to proactive and systemic dispute identification and resolution, moving away from the current highly reactive 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.
5. Automated settlement functionality and infrastructure connectivity
Firms, specifically on the buy side, continue to rely on manually entered payment and settlement instructions and settlement monitoring. This presents challenges in delivering operational efficiency, optimization capabilities and effective risk management. When firms consider their operating model, ensuring an end-to-end approach is adopted will require them to consider the scalability of their settlement processes. Specific opportunities that firms need to address include the following:
- Develop connectivity with settlement infrastructure leveraging SWIFT or SWIFT-like messaging and supporting workflow to eliminate manual paper-based wire processes, enhancing resiliency and control
- Establish an automated and predictive fails process to monitor inbound and outbound settlements for potential challenges and fails to move to a proactive T0 control from a reactive T+1 or longer reconciliation
For each firm, the operating model that best suits its needs is available. With advancing innovation, the number of providers in the market and increasing complexity of the process, it can be challenging to find the best fit. A pragmatic and rapid business case and target operating model analysis is a must as firms future proof their organization to learn from the pandemic and meet regulatory expectations.