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NIIT Technologies White Paper

Nidhi Lall

Collateral ManagementCollateral Management

Executive Summary 3

Collateral Management and Market Developments 3

Collateral Management – Features 4

1. Bi-Party Collateral Agreement

2. Tri-Party Collateral Agreement

3. Collateral Trading and Re-hypothecation

4. Repos and Repos Market

Collateralized Relationship Structuring 3

1. Credit considerations

2. Determine eligible collateral for the counterparty

Implementing the Collateralized Relationship 6

Best Practices 7

1. Revalue Collaterals

2. Maintaining Critical Buy Side Relationships

3. Regular and Frequent Portfolio Reconciliation

4. Outsource Collateral Management

5. Build and Buy Systems

Role of Technology in Collateral Management Systems 8

Conclusion 8

CONTENTS

INVESTMENT

REVENUEREVENUE

INVESTMENT

INVESTMENT

INVESTMENT

FINANCE

FINANCE

FINANCE

FINAANCEFINANCEWEALTH

MARKET

MARKETMATKET

CAPITAL

CAPITALCAPITAL

CARGO CAPITALECONOMICS

ECONOMICS

BANKING

Banks and Financial institutions are under immense pressure in

every area of their business with the introduction of new rules and

market changes from the Global regulators. With ~90% of firms

reeling under pressure from aggressive regulatory changes and

over 35% facing compliance, administrative and reporting burdens

(Celent, 2013), collateral management has become the top priority

for the banking and capital markets industry. It is no longer

recognized as a back office function but has evolved as a major

challenge for both banks and financial institutions to convert

outmoded spreadsheet based systems to an automated and

advanced collateral management system.

Executive Summary Financial institutions need accurate and sophisticated enterprise wide

approach to keep their collateral inventory optimized while generating

revenue and reducing costs. This paper provides an insight into

Collateral Management, in the current economic scenario. The paper

provides a broader view on how technology bridges the gap and also

enumerates the best practices that financial institutions must follow to

improve collateral management process.

Collateral Management and Market DevelopmentsCollateral is any asset that is used to secure a borrowing. It is a

guarantee that the cash borrowed by the counterparty would be

returned back at the predefined time. When two parties engage in

Collateral Agreement, the lender reduces Credit risk while lending

cash and the borrower gains favorable conditions for financing.

Collateral Management assists organizations to mitigate Credit

risk, by accepting a similar valued asset in return for the loan/cash

lent. Collateral Management reduces risk between the lender and

the borrower and is effective when it constantly rebalances

exposure as per changes in prices and regulations. Collateral

Management has developed as a strong Business practice that

forms the core aspect of the organization.

Collateral Management has undergone a major transformation after

the collapse of Lehman Brothers and the onset of the financial crisis.

The credit crisis of 2008-09, along with freezing of credit markets

and increased volatility resulted in the introduction of new regulations

(BASEL III, CRD IV, EMIR and Dodd Frank Act) and high volumes of

collateralized loans. In Europe, banks had a shortfall of €374.1 billion

(Quantitative impact study by Basel Committee, Sep 2012) to

comply with additional liquidity requirements of Basel III.

Collateral use in the market has increased. According to ISDA survey

in 2013, the $3.7 trillion estimate of total collateral in circulation is

based on total reported collateral amount of $2.67 trillion. With the

increase in collateral circulation it is important for firms to implement

robust, automated collateral management solutions to support

evolving market and regulatory needs.

3

Exerts biggest impact on the economics of trading derivatives

75% Dodd-Frank 65% EMIR

Estimated Reported

4500

4000

3500

3000

2500

2000

1500

1000

500

02009 2010 2011 2012 2013

31512934

36523700

21501984

245926662649

3957

Year

Growth in value of reported and estimated collateral (USD billion)

OTC

Con

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After millions of dollars were lost when the financial institution

Lehman Brothers collapsed, industry demanded better collateral

management. Industry initiatives required firms to consider

smarter ways of using the limited collateral available. Financial

institutions were forced to focus on counterparty credit risk and

the wide use of derivates and the entire collateral management

process. Regulatory changes also called for additional collateral

and margin requirements for large and complex derivatives. The

implementation of global regulations such as Dodd Frank Act,

EMIR and other capital regulations emphasized to automate the

collateral management systems in order to manage them with

ease. Automating collateral management systems mitigated

systemic risk and increase transparency in Over-the-Counter

(OTC) trades, and pre- and post-trade financial transactions.

However, to prepare for the changes firms needed investment in

technology. Technology helped firms in looking at the collateral

holistically and facilitated clearing. According to a survey by a

research firm Celent in 2012, an estimated 40-50% of OTC

contracts are expected to be cleared by the end of 2013, leaving

a $2.5 trillion to $6 trillion collateral hole to fill.

The enterprise collateral management challenges from the

inefficiency of collateral silos also resulted in the implementation of

new processes and procedures to manage current and future

collateral management needs. There was an immediate need to

link collaterals to credits. After the financial crisis, the amount of

uncollateralized credit available between transacting

counterparties has sharply fallen down. Decrease in the

uncollateralized credit increased the demand for collateralized

credit, which in turn generated interest in the mechanisms

available to support collateralized solutions.

Once the market became stable, capital market industry started

considering collateral management as a core function fully

integrated in the management of financial institutions and closely

linked to treasury, trading, risk management, operations, finance

and capital management.

Collateral Management – FeaturesCollateral Management has evolved for hundred of years, from a

single, ancillary function of an organization to cover a

comprehensive list of functions and features. Some of them are:

Bi-Party Collateral AgreementBi-Party agreements are collateral agreements where two

parties interact among themselves and form a collateral

agreement without any interference from a third party or a

centralized bank. The Bi-Party Collateral Agreements are over

the counter agreements customized according to the needs. It

is a two-legged transaction – Initiation of the Agreement and

Termination of Agreement.

4

90%

80%

70%

60%

50%

40%

30%

20%

10%

0%2012

40%50%

60%

70%

80%

2013 2014 2015 2016

Source: Morgan Stanley, Oliver Wyman, Celent

OTC

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trac

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lear

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P

Centrally Cleared OTC Contracts Will Leave a $2.5 Trillion to $6 Trillion Collateral Hole to Fill

Bi-PartyCollateral

Agreement

CollateralTrading and

Re-hypothecation

Repos andRepos Market

Tri-PartyCollateral

Agreement

Tri-Party Collateral AgreementTri-party Collateral Agreement involves third parties during the

transaction. Third party is an intermediary during the entire

process and usually the Custodian Bank of the firms. The

Custodian bank is the safe-keeper of the Collateral for the Lender,

and assists in transferring funds from the Lender to the Borrower.

Collateral Trading and Re-hypothecationCollateral Trading is done to free resources for working capital

requirements by the bank. It traditionally involves few market

participants and represents a very small proportion of total trading.

Re-hypothecation, on the other hand, is the process where the

secured lender extends the collateral posted, by either lending or

posting it as collateral to another party. It is also done to free up

collateralized capital.

Repos and Repos MarketRepo is an agreement in which one party sells securities or assets

to counterparty and simultaneously commits to repurchase the

same at an agreed time. The repurchase price is equal to the

original sale price plus interest on the repurchase price.

Collateralized Relationship Structuring1. Credit considerationsStructuring of collateral relationship involves credit considerations

to be followed. These considerations are:

1.1 Is collateral a suitable credit enhancement tool?

To determine whether collateralization is appropriate, financial

institutions must analyze the counterparty’s financial position. It is

important for firms to note that collateral does not turn a bad

counterparty into a good counterparty without eliminating credit risk.

A collateral arrangement provides assets of value during

counterparty’s default or bankruptcy/insolvency. A financial

institution loses funds only under a fully collateralized arrangement.

If the direct counterparty defaults during the default period (prior to

liquidation of the collateral), there is a significant increase in MTM

exposure or decrease in collateral value held after taking into

account independent amounts (initial margin) and haircuts on the

value of the collateral securities.

1.2 Determine the Credit Type of the Counterparty

It is always helpful to determine the counterparty’s ability to

• Deliver collateral on a timely basis or hold collateral

• Measure collateral requirements on a daily, weekly or monthly basis.

1.3 Determining the Appropriateness of Collateral

Upon successful completion of credit analysis and gathering of

general counterparty information, the credit officer must determine

whether the collateral is an appropriate credit enhancement tool.

He must identify appropriate credit support terms to negotiate. In

some instances, other provisions, such as guarantees or an option

to terminate the transaction may be helpful.

5

Triparty Collateral Management

Triparty Service Agreement

Neutral Agent

CollateralGiver

Eligibility Set 1• Eligible: AAA - A• No concentration• x % haircut

Eligibility Set 2• Eligible: AAA - BBB• only y % of BBB• z % haircut

CollateralTaker

The Collateral Management Outsourcing Solution

Bi-lateral Contract

Operating ProceduresTerms and Conditions

Eligbility profileConcentration profileMargin percentages

they should be valid enough to provide deemed ratings for

collateral. However, revealing credit ratings may have confidentiality

implications. Therefore, confidentiality of the use of internal credit

ratings must be agreed upon between counterparties before they

are shared with the outside world.

Collateral quality is difficult to gauge for equities. However, listing

on the major exchanges and especially in the prime indices (such

as the S&P500, the FTSE100, DAX30, CAC40 or Nikkei 225) is

generally viewed as indicating greater liquidity of the collateral.

2.1.4 Instrument Tenor (Time Remaining to Mature)

Collateral is group of tenor buckets with tenors measured as

residual maturity rather than original maturity. Existing collateral

agreements refer to original maturity but measure residual maturity

suggesting a need to amend the agreement. However, in this

dispute of original maturity vs. residual maturity oral arrangement

may not be enforceable.

2.1.5 Avoid Strong Correlation to Exposure

Collaterals with strong correlation to underlying exposure are not

appropriate as their value always decreases when the exposure

increases. These collaterals are always unacceptable even if they

qualify under all acceptability criteria. In certain circumstances, the

collateral chosen may specifically offset the liability because of its

strong correlation to the liability, creating a covered trade.

2.1.6 Avoid Positive Correlation to Collateral Giver

Any collateral whose value correlates directly and positively to the

collateral giver’s credit standing is usually not acceptable.

Securities or any related equity issued by the collateral giver is

normally not accepted as collateral.

Implementing the Collateralized RelationshipCollateral management complicates the handling of relationships

between two parties under one agreement for one line of business.

A firm may be doing business with the same counterparty out of

multiple entities in different jurisdictions for tax, accounting,

regulatory or other reasons.

Due to volatile market and jurisdictions, collateral management has

to resolve the following issues that may arise:

• Counterparty initiates multiple calls for collateral to secure

various exposures;

2. Determine eligible collateral for the

counterparty

2.1Considerations for Selecting Appropriate Collateral

Appropriately selected collateral gives financial institutions

protection against counterparty risks and may reduce capital

costs. Poorly selected collateral gives rise to unacceptable levels of

price risk, liquidity risk, operational risk and legal uncertainty. The

following criterion has been used as a basis for determining

collateral eligibility.

2.1.1 Liquidity

Firms should consider credit rating, currency, issue size and the

frequency of price updates to understand the liquidity of the

collateral. If the price for a particular item of collateral is not

available, the firm must interpret it as a significant downturn in the

liquidity of that asset. It is advisable to establish a liquidity threshold

below which an item of collateral is valued as zero.

2.1.2 Volatility

Highly volatile instruments should be subject to lower

concentration limits and higher haircut rates in order to be

accepted. The haircut computation methodology ensures that the

price volatility is factored into the haircut. When establishing initial

margin levels or haircuts, it is important for the firms to understand

that operational risk is generated by the delay between the time at

which a margin call is made and the time at which the collateral is

delivered. During periods of extreme market volatility, if the

collateral call is made on day T while delivery of the collateral will

not take place until T plus one day, a lag of one day will create

operational risk. It is, thus, inadvisable to accept collateral subject

to long settlement periods. Initial margin levels and haircuts should

be established at all levels to take account of this risk.

2.1.3 Collateral Quality (Credit Rating)

A minimum acceptable credit rating is often stipulated for all bonds. If

a bond is not rated by an agreed rating agency (e.g. S&P or Moody’s),

the bond should undergo a deemed rating process. In deemed rating

process, firms must review ratings accorded by an agreed rating

agency to senior unsecured issues by the same issuer, and accord a

similar deemed rating if the issue in question is not subordinated. If the

issue being assessed is subordinated, the deemed rating is two to

three modifiers lower than the rated issue.

An alternative source is credit department of a financial institution.

If credit decisions are based on internal risk ratings,

6

• A call for collateral may be initiated by one entity while another

entity is returning collateral to the same counterparty. At this

time, both the parties run the risk of over collateralizing on a net

basis; and

• Relations with counterparty may be governed by multiple

agreements with different terms covering different products that

may overlap.

Monitoring collateral positions and tracking collateral movements

requires both parties to have systems that can handle collateral.

Firms need to automate the entire collateral management process.

With automation, additional administrative burdens come in the

form of monitoring or tracking the securities that are subject of a

collateral agreement, performing daily MTM calculations and

handling margin calls.

Best Practices

Revalue Collaterals

Financial institutions must revalue and monitor collaterals against

outstanding debt on a regular basis. The frequency of revaluation

will depend on the following two factors:

• Type of collateral – Security collateral or cash collateral Security

collateral including accrued interest should be revalued while

cash collaterals exclude accrued interest while revaluation

• Market conditions - Time, Market volatility, Finance availability,

Economic environment, Lack of maintenance etc.

Maintaining Critical Buy Side Relationships

Relationships for the buy-side are extremely critical for

understanding collateral demands in both bilateral and central

counterparty world. Hedge funds, asset managers and insurance

companies still look at primary service providers to offer best deals

across multiple products on a holistic basis.

Regular and Frequent Portfolio Reconciliation

Detailed portfolio reconciliation should be performed regularly or

prior to the first margin call. If it is not done regularly/frequently, the

collateral that flows back and forth is based on the estimate of the

exposure; which is not considered a sound basis of

collateralization.

Regular portfolio reconciliation reduces the frequency of

collateral disputes. In order to resolve collateral disputes, the

most effective way is to extract trade files from the collateral

system on a regular basis.

Outsource Collateral Management

Fewer than 50% have outsourced collateral management, 25%

have deployed vendor collateral management solutions internally,

with the remainder reliant on bespoke applications and

spreadsheets (ISDA, 2012). In an outsourced collateral

management system, it is easy to retain bilateral relationships with

preferred counterparties. The outsourced solution will also enable

counterparties and investment manager to focus on making

strategies rather than worrying about the operational, regulatory

reporting and transaction requirements.

7

Revalue Collaterals

Maintain Critical Buy Side Relationships

Regular and Frequent Portfolio Reconciliation

Outsource Collateral Management

Build and Buy Systems

• Scalability and economies of scale to handle increased volume

of collateral

• Capability to efficiently calculate Mark to Market calculations

• Risk management and alert mechanism with audit features to

handle market volatility

• Reporting capabilities to handle legal and documentation

requirements

• Capability to manage disparate systems, data capture from

several sources, margin call calculations etc.

ConclusionThe changing regulatory and trading environment has necessitated

the need to revisit the existing collateral management processes

that involves integration with third party institutions, platforms and

applications. It involves precision, accuracy and timely flow of data

to margin management and calculation systems. Any discrepancy

in data can result in financial institution insolvency.

Collateral management is not a perfunctory back office function

but considered a core function. NIIT Technologies with 15000 +

person years of experience in capital market domain have

in-depth expertise in regulatory and change management

functions. We evaluate the existing systems and identify the

shortfalls. NIIT Technologies provide services in the area of

collateral management, third party feeds and data provider

integration, enterprise data management, order and trade

management, risk management, fund accounting, margining

and netting, and reporting.

A solution that mitigates risk, processes collateral information

consistently across clearing methods and asset classes, and

meets new regulation and industry best practices can

dramatically change the dynamics of the collateral management

market. NIIT Technologies has the know-how and solution to

develop and automate the collateral management process with

proven industry knowledge. These strengths have led to a large

ecosystem with a large number of partners utilizing our

collateral management systems.

8

Build and Buy Systems

Financial institutions struggling hard in collateral management and

OTC derivatives must invest in plug and play type of systems. They

can purchase or lease systems locally or via a hosted solution from

a dedicated or a bundled service provider. The systems developed

by service providers can be customized to meet the collateral

management services needs. Build and Buy systems strategy is

the most popular technology strategy with core functionality

integrated into existing systems.

Role of Technology in Collateral Management SystemsTechnology plays a critical role in Collateral Management Systems.

Collateral management requires compatibility and seamless

integration with third party platforms and applications like Order

and Trade Management, Trading Platforms, Risk Management

Systems and External data feeds for running the business in a

seamless manner. A centralized system can process and manage

collateral requirements and at the same time handle increased

volumes and agreements.

In the current market scenario, technology

• Improves the efficiency of information and allows market data to

move swiftly

• Makes the system efficient and capable of handling mark to

market calculations

• Achieves cross product netting, collateral optimization and

management of new regulation requirements.

The collateral management systems should evolve in technology

with changing times and should always reflect the true picture of

the market. It should integrate all functions like business

operations, legal documentation etc. to ensure that the system has

core functional capabilities.

A typical collateral management system should provide

• Integration with market data feed providers

• Integration with all third party platforms and applications

• Integration with third party institutions involved in collateral

agreements

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