FROM SAFETY TO PROFIT TOOL: COLLATERAL OPTIMIZATION

Interview with Judson Baker, Senior Vice President and Product Manager of Derivatives at Northern Trust.

Judson Baker, Senior VP and Product Manager of Derivatives at Northern Trust
Judson Baker, Senior VP and Product Manager of Derivatives at Northern Trust

The past year and a half has seen collateral management evolve from a back-office concern, to a middle and front-office operation. The Dodd-Frank Act, devised as a solution to the financial crisis, has had a profound effect on the market, which many are still learning to manage effectively. The threat of new uncleared margin rules (taking effect in September 2016), has meant that remodeling to comply with Dodd-Frank has taken on a whole new dimension of difficulty—both operationally and theoretically.

Judson Baker, Senior Vice President and Product Manager of Derivatives at Northern Trust, recently spoke with GFMI about topics to be discussed at the upcoming Collateral Excellence Conference:

How is the buy side dealing with the legacy of Dodd-Frank title VII?

JB: Firms on the buy side that have and continue to trade derivatives have been forced to adapt to a series of rules and market practices as a result of the derivative regulations. For some firms, the impact was relatively contained. However, for firms active in derivatives or with significant exposures and dependency to these products, the cost of change has been considerable. For the adoption of central clearing of swaps—coupled with the increase in margin requirements, the impact to the trade modeling and execution process, and now additional margin requirements on uncleared swaps—the regulations hit front, middle and back offices of the asset management community.

What are the likely challenges that uncleared margin rules will bring for the buy side?

JB: The uncleared swap margin rules have two components: initial margin and variation margin. Only those buy-side firms with very significant derivatives exposures will need to comply with the initial margin rules over the next couple years. However, the variation margin component to the rule will have a much broader impact to the buy side by March 2017. Firms will be mandated to re-paper their credit agreements by adopting certain language regarding thresholds, minimum transfer amounts, and eligibility rules. The legal exercise should be interesting and firms are encouraged to get a jump start on this component. Operationally, many firms can and do support variation margin or collateral management as prudent counterparty risk management standards. This is one more area that competes for high-quality liquid assets and will cause some firms to consider the most efficient use of their cash and securities, so as to not disrupt their core investment strategies.

How will it be possible to optimize collateral under the new legislation?

JB: We are seeing growing concern from asset managers around the impacts of various emerging regulations and market trends, as well as what they mean to their businesses and their margining arrangements. The collateral industry is going through some degree of transformation as new requirements are phased in. Firms are increasingly looking to secure liquidity through the financing markets, further fueling the need for collateral to be used as security and margin. Asset managers need to understand the impacts, and establish new processes in order to successfully navigate the challenges over the upcoming months.

There are a number of challenges that are common across the buy side, each with varying degrees of impact depending on the type of firm or strategy:

  1. The tighter eligibility criteria around acceptable collateral increases pressure on high-quality liquid assets. As a result, some firms may need to source additional eligible securities or raise cash in the repo or securities lending market. Firms will find themselves competing internally for high-quality assets, for example government bonds and cash to support their trading strategies.
  1. There are increasing levels of high-quality liquid assets leaving the safety of custodians, leading to a potential lack of transparency, increased transit risk (credit exposure as collateral flows via clearing members to clearing houses), and transformation risk. This is of particular concern to the asset owner community.
  1. In order to meet requirements, collateral must often be managed across multiple silos, such as bilateral OTC, cleared OTC, listed derivatives, repo financing, and securities lending. The resulting portfolio bifurcation will lead to operational complexities as separate workflows will be necessary for cleared and bilateral trades.
  1. As firms are clearing swaps, they will be are facing compressed deadlines to deliver margin as a same-day process.
  1. The steep increases in the volume of collateral movement equate to additional operational overhead and risk.

How will the buy side overcome operational complexity in order to do this?

JB: In order to respond to the growing demands, a sound, scalable collateral management solution is essential. Firms should focus on these key areas:

  1. Centralization of collateral management

Across the industry, about 15 percent of firms choose to outsource their collateral management, which is largely affected by the size of the firm. While small firms often choose to manage their collateral in-house, nearly a third of large firms opt to outsource their collateral management to a custodian1. There is interest from firms of all sorts and sizes, and smaller firms may find the onslaught of new requirements a catalyst for rethinking their strategy. Where asset owners may be utilizing multiple external investment managers, each may be margining against the same counterparty and selecting collateral from stand-alone pools of assets. Centralization of collateral management promotes the netting and efficient selection of assets.

  1. Collateral efficiency

In order to meet requirements, collateral must flow more quickly and in higher volumes through the system, while establishing transparency and risk reduction. Phone calls, faxes, and emails are often no longer practical and introduce potential errors. New forms of collateral messaging aim to automate reduce latency and standardize the flow of collateral. There has been significant uptake of such messaging by the sell-side dealer community and this is supporting the adoption across the industry. Furthermore, there are a number of collaborative initiatives emerging within the industry that aim to simplify margin-related securities settlements.

  1. Collateral optimization

In order to maximize the power of their collateral, firms are seeking to implement optimization strategies in order to select securities and cash to cover margin calls as efficiently as possible. A central tenet to a sound optimization are algorithms that may be applied against daily margin requirements and the inventory of available assets. These can identify the least expensive collateral to deliver and highlight revenue opportunities where specific securities may be lent through repo or securities lending markets. Amendments to asset allocation and trading strategies can also improve margin offset and keep collateral requirements as low as possible.

To assist the asset management community, custodians and software providers have stepped up their service offerings through significant investment in their derivatives and collateral servicing capabilities over the past years.

Judson Baker serves as Senior Vice President and Product Manager with a focus on derivatives and collateral management. He is responsible for coordinating and developing Northern Trust’s investment operations outsourcing, fund administration and custody services as they relate to derivatives. This includes innovation and development, global expansion, and overall strategy for derivative services.

Prior to joining Northern Trust in 2006, Judson helped to develop a Product Control group at Citadel

Investment Group for two years. He managed a team that was primarily responsible for the independent price verification as well as profit/loss reporting and analysis for all traded products. Prior to joining Citadel, Judson spent seven years at Bank One focusing on derivatives. In his later years at Bank One, he was an Equity Derivative trader within the firm’s Capital Markets area.

Join Judson Baker at the Collateral Excellence Conference, May 16-17, 2016 in New York. View the conference agenda to check out Judson’s case study topic. For more information, please contact Jen

Jordan, Digital Marketing Coordinator, GFMI at 312.894.6347 or jenjo@global-fmi.com.

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