Collateral optimization is the systematization of collateral management into a profit centre or ‘collateral hub’. It facilitates stringent regulation of collateral risk and collateral usage costs across the enterprise. It would then be possible to optimize the collateral inventory, covering various trading prospects and internal & external business lines.

The new regulations mean that a distinct trade consisting of collateral would need pre-trade analytics, and hence OTC derivatives users require to verify, reflect and forecast CCP margin.

An increase in market complexity means that the lifetime capital cost and margin cost of the trade would be interfaced into the implementation price.

Hence, banks would have a need to estimate bilateral and cleared margin and PFE at the time of trade execution to ascertain the accurate price. Firms would deliver an optimal collateral after the calculation of IM and VM needs is known.

Collateral management has witnessed development based on two separate but interrelated methods:

Efficient Risk Management

Firms are using advanced systems to monitor and regulate counter-party credit risk. It consists of determining the possibility of a counter-party default. It also involves an insight into the liquidation process of a collateral due to a default.

Firms are leveraging intricate collateral acceptability, awareness and haircut rules to reduce risks and execute technology systems in support.

Cost Reduction

Collateral management has diverged into a cost reduction process. A restriction on exceptional quality means firms are looking to oversee the collateral flow and its balance sheet usage in an effective method.

Collateral optimization is unique to every firm. The accurate description of optimization relies on the exceptional strategy and business model of every firm. Optimization objectives differ for every firm along with the probable cost reduction. This is to a great extent depends on aspects like

Magnitude of the business.
Products dealt with.
Geographical impression.
Quantity processed.
Risk profile.
Development plan.
Improvement in counterparty credit risk.
Capability to consolidate product silos.

Due to these factors, technology projects for optimization normally involve an extraordinary level of process mapping and expansion of custom algorithms for every firm. A customized method for optimization does not exist. Technology stakeholders must be adjustable in fulfilling client requirements instead of providing a generic solution.

There are several elements impacting the optimal use of collateral. There is competition among desks for collateral (derivatives, securities, lending, repo, treasury). It would be prudent for a particular section or individual to monitor the complete collateral function covering the firm and plan the deficient resources allocation.

An interface between the supply and the demand side aspects result in a liquidity crunch as collateral supply decreases while demand for exceptional collateral enhances concurrently.

Who Benefits from Collateral Optimization?

Sell side

Firms managing huge volumes of trades and collateral activities would benefit significantly from optimization. The connected effects of huge quantities of small cumulative decreases on the collateral cost for every trade could lead to a substantial improvement to the bottom line.

Mega sell side firms managing several trades covering various products could provide maximum ROI on collateral optimization. However, it is feasible for smaller institutions to accomplish quantifiable cost savings from optimization.

Buy side

Previously, buy-side firms needn’t emphasize collateral management and did not invest much into technology structures and processes. However, due to a need, market and regulatory transformation is compelling the buy side to make investments in collateral management and optimization.

Collateral optimization is still in its early stages and there is a fluctuating scale of complexity to the optimization process. Hence, it is not clear if even the most tech-savvy firms are presently using the efficient optimization methods.

It would be feasible to have a standard of collateral optimization in the future to balance the supply and demand for collateral with robust risk management and insignificant effect on the balance sheet.

Measures required to construct the fundamental framework for collateral optimization:

  • Allocating costs to collateral assets.
  • Grading acceptability benchmark.

Normal Optimization

Normal optimization can be conducted if a collateral has been allocated a cost and suitability rules have been established. Though it can result in cost savings, the model does not use a complete set of assets available as collateral throughout the firm in a combined method.

Business-Wide Optimization

The next phase in accomplishing optimization is to centralize collateral assets across the business verticals of the firm to develop the collateral ‘hub’.

Inventory feeds from various sources are updated in the collateral management system and arranged into a business and book hierarchy system.

This enables the individual to view exposures across levels. Risk stakeholders can have a holistic approach to exposures and risk throughout the firm. It is feasible to monitor the firm’s actual exposure number across various products and counterparties in a distinct structure.

Cross Product Optimisation

Centralization ensures the creation of a distinct collateral set covering all asset types. Traders would be able to view all existing assets across different levels of the firm, expeditiously. This delivers the information required to optimize the inventory usage for collateral financing.

The benefits of Optimization

  • Effective management of collateral supply and demand.
  • Emphasize collateral shortcomings.
  • Avert over-collateralization.
  • Efficiently determine excess collateral that has not been used.
  • Ensure proper use of liquidity.
  • Secure a wider array of collateral.
  • Obtain transparent estimates for real and optimal collateral costs.
  • Identify differences between the collateral that is received and the collateral that can be guaranteed.
  • Estimate collateral needs precisely.
  • Facilitate compliance with regulations needs and reporting easily.
  • Improve customer service and provide excellent customer pricing.

Several financial firms are utilizing legacy systems to manage collateral. A vendor solution for collateral management could be efficient. Collateral optimization is one tool among many that firms can use to address the collateralizing cost of the business.

The critical factors in ensuring improved performance for a firm is in establishing the vital objectives for each process and executing a holistic method for the short-term with the possibility to enlarge in scope and complexity as the operations requirement becomes clearer.

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Source by Ralph waldo