Collateral Management in FocusAt a time when collateral is getting scarce and markets are volatile, banks need to adopt better tools and technology to manage the risks on their assets and optimize allocation of assets across counterparties in the most efficient way possible.

Executive SummaryThe recent economic crisis, especially the sovereign debt crisis in Europe, has swung the spotlight onto credit risk mitigation mechanisms including collateral management. New regulations such as Dodd-Frank, EMIR and BASEL III demand better management of liquidity and credit risk. Financial service organizations are therefore realizing the need for efficient collateral optimi-zation platforms as well as the need for collateral management across diverse asset classes.

In this paper, we examine the regulatory and business forces shaping the securities industry, the resulting impact on collateral management and how firms need to respond to new technology needs in the wake of these changes (see Figure 1).

Drivers of ChangeThe Dodd-Frank Act in the U.S. and the EMIR rules in Europe are at various stages of implementation but have already begun impacting the post trade industry, particularly in collateral management. Moreover, financial institutions are realizing that collateral optimization across multiple product lines and geographies will result in significant cost savings.

Introduction of Central Counterparties

The Dodd-Frank Act mandates that all standard-ized derivatives be cleared via a central clearing counterparty (CCP). The European Securities and Markets Authority (ESMA) requires OTC derivative trades to be cleared by an authorized CCP. Certain nonstandard OTC trades that are unsuitable for clearing by a CCP are subject to stringent internal governance, audit checks, higher capital require-ments and operational risk management require-ments for collateral valuation, reconciliation and dispute resolution.

Margin Requirements

CCPs are now enforcing stringent initial margin requirements and clearly defining the acceptable security profiles. In addition, the cost of sourcing collateral assets for initial margin is higher if the margins are segregated rather than being paid on an omnibus basis.

Liquidity and Quality of Collateral

Capital adequacy requirements under the Basel III accord have limited banks’ ability to deploy liquid assets. CCP margin mandates have aggravated the liquidity crunch for quality collateral. Most CCPs restrict acceptable assets to cash or high-grade bonds such as U.S. Treasuries or EU bonds.

• Cognizant 20-20 Insights

cognizant 20-20 insights | june 2013

2

Stringent Risk Management

In the wake of the new regulations, financial insti-tutions need to strengthen their risk coverage for the capital held by maintaining more granular data with historical trends for a detailed view of risk across the enterprise. They need to enhance their internal rating-based models for credit risk management to determine different risk measures such as probability of default (PD), exposure at default (EAD) and loss given default (LGD). Moreover, a large institutional counter-party may need to deal with multiple CCPs, which would require optimal allocation of its portfolio to meet individual CCP requirements.

Banks will need to consider the potential credit risk losses due to deterioration of credit quality of the counterparties (known as credit value adjustment) in counterparty credit risk (CCR) cal-culations and perform stress testing and scenario analysis to identify potential risk factors. However, an overly conservative approach to risk-weighted assets valuations would decrease the capital for the front office.

Banks are looking at firm-wide collateral holdings across all asset classes and the firm’s operating geographies as inputs for calculating credit exposure and counterparty risk calculations.

Mandatory Reporting

In the G20 leadership summit in 2009, it was agreed that all standardized OTC derivative contracts should be reported to trade reposito-ries (known as the swap data repository in the

U.S.). The trade repositories will be the authorita-tive source of OTC derivative trade information. EMIR requires that all EU trade repositories must register with ESMA while Dodd-Frank mandates that all U.S. trade repositories register with CFTC. Non-EU or non-U.S. trade repositories also need to be recognized by ESMA or CFTC to enable trade with EU- or U.S.-based counterparties. Regulators will have access to these repositories, allowing them a better overview of trade positions and helping them to detect any potential problems such as accumulation of risk for a specific coun-terparty. In addition, trade repositories will have to publish aggregate positions by each asset class to give all market participants a clearer view of the OTC derivatives market. New legal documen-tation will be introduced in addition to current ISDA agreements.

New Players and Revenue Opportunities

Nontraditional participants such as monetary authorities and government agencies are also collateralizing their repo trades and derivative transactions with pension funds as the underlying assets. CCPs now need to manage an increased volume of collateral due to the influx of OTC derivative trades. These new players seek assistance from agents offering tri-party collateral management services to manage operational and counterparty risk at an enterprise level. Large custodians such as BNY Mellon and J.P. Morgan hold trillions of dollars of assets in custody. They are positioning themselves to set up an efficient supply and demand matching of collaterals by integrating collateral management services

cognizant 20-20 insights

Figure 1

Evolving Collateral Management Landscape

Introduction of CCPs

Margin Requirements

Risk Management

Mandatory Reporting

Collateral “Crunch”

Cross-Border CM

New Types of Collateral

STP of Collateral Transactions

Efficient Security Movements

Cross-Border Links

Dispute Resolution System

New Players

Dispute Management

Drivers of Change Impact on CM Technology Adaptation

Liquidity and Quality of Collateral

Focus on Collateral Optimization

Less Collateral Re-hypothecation

Real-Time Valuation and Reporting

Integrated Collateral Management

Reporting Infrastructure Upgrade

Collateral Optimization Engine

across multiple asset classes. Nonbanking firms such as clearing agencies and securities deposi-tories are also looking to capitalize on this oppor-tunity. Euroclear is creating a collateral highway — a first-of-its-kind international market infra-structure to mobilize collateral where needed.

Impact on Collateral ManagementThe macro-trends in the securities market described in the previous section have begun to have a significant impact on the collateral management industry.

Collateral “Crunch”

The collateral process involving CCPs has created a larger cost burden for financial firms. Working with a CCP involves direct costs such as system and operational changes, as well as paying membership fees for being a clearing member. Moreover, the initial margins on transactions with CCPs are higher than those of OTC transactions. One CCP does not cover all asset classes/geogra-phies; hence, a large financial institution has to enter into agreements with multiple CCPs, which increases the cost.

Finally, the new capital adequacy mandates for banks mean that they need to maintain a larger share of liquid assets in their inventory, thus reducing the supply and increasing the price of quality assets.

The pressure on banks to find this extra collateral, combined with demand from clearing houses for only the best collateral, is giving rise to a “collateral crunch.”

Banks have devised several ways to make the best use of the collateral available on their balance sheets:

• Cross-border collateral management: For mul-tinational banks that hold assets across several markets, we have noted an increased adoption of cross-border collateral management. In this model, idle assets in one country (market) can be used as collateral in another country. In Eu-rope, this is being enabled by the correspondent central banking model (CCBM), which allows a counterparty to use eligible assets issued in other Eurozone countries as collateral.

• New collateral types: Another trend is the in-troduction of new asset classes such as com-modities and letters of credit as collateral. Al-though this results in a larger pool of assets, new concepts and guidelines are required to determine eligibility, margin and haircuts appli-cable for these asset classes.

• Collateral optimization: With the increased demand for safe and high-quality assets, collat-eral optimization is gaining momentum to en-sure assets are deployed as efficiently as pos-sible. In the current economic scenario, optimal allocation of collateral can lead to significant savings even after accounting for the cost of an advanced optimization engine.

However, collateral optimization is easier said than done. The collateral giver and the collateral taker agree to a security eligibility profile for their transactions based on various criteria such as haircut, security rating, issuer type, market type (e.g., first domestic then international) and transaction amount. Some of the criteria are mandatory while some are optional but are considered in order of preference. Complex algorithms are required to determine optimal securities from a collateral pool that satisfy the mandatory criteria.

Maintenance of the collateral pool is vital for optimal allocations. The long trail of collateral movements due to reuse needs to be tracked. Collateral receivers have increasingly taken to changing the eligibility criteria frequently, resulting in additional responsibility for the collateral giver to reallocate using optimized techniques. The optimization process must be run multiple times in a business day to take into account the most up-to-date securities positions. After the closure of a business day, a complete reallocation of securities is required for all the open trades. This removes any inef-ficiency in collateral allocation due to the rapid and frequent nature of trades.

• Reduced collateral re-hypothecation: Post the collapse of Lehman Brothers in 2008, the re-hypothecation of collateral has dipped (see Figure 2).

Clients have become more cautious and are including clauses in the contract to limit the amount of collateral that can be reused. Also, to meet the liquidity standards participants are trying to hold more high-quality liquid assets as part of the on-balance-sheet assets. As only off-balance-sheet collateral can be reused, the volume of collateral being reused is lessening. According to a working paper published in 2010 by the International Monetary Fund,1

the collateral received that could be reused by the seven largest U.S. broker-dealers had decreased from about $4.5 trillion at end-2007 to $2.1 trillion by end-2009.

3cognizant 20-20 insights

cognizant 20-20 insights 4

Need for Real-Time Valuations and Reporting

Collateral valuation is moving toward intraday and real-time valuation from the tradition-al end-of-day/weekly valuation. Up-to-date valuations being factored into pricing and trading decisions will lead to high-frequency exposure management. In order to support this, the reporting needs to be real time as well. Moreover, the extent of reporting is wider nowadays, covering collateral valuation, portfolio reconcili-ation, forecasting, exposure calculation, margin calls, intraday liquidity and dispute resolution.

Dispute Management

In the current regulatory maze, firms face a sig-nificant operational risk from the time lost in resolving disputes. Counterparties are increas-ingly agreeing to a transparent dispute resolution protocol in their contract and adopting active portfolio reconciliation to minimize disputes. The ISDA master agreement is the most commonly used contract for OTC derivatives. It provides a standard protocol that sets out strict guidelines and timetables for dispute resolution. For example, it requires that in the case of a dispute the undisputed collateral amount (the lower value of both counterparties’ estimates) must at least be moved immediately. Dispute detection and its timely resolution is becoming an important part of a collateral management setup.

Adapting the Technology PlatformTechnology and automation are critical to keep pace with the changes in regulatory and client

demands. We see firms investing in technology solutions to bolster straight-through processing of trades by embracing a standard messaging channel with external entities such as settlement systems, CCPs and depositories. An integrated view of collateral across asset classes, currency markets and geography and a rule-based collateral optimization engine are becoming crucial needs. Also, frequent changes in margin requirements and the increased regulatory focus on transparency have resulted in the demand for a dispute resolution system (DRS) for collateral management trades. The major areas to watch in the evolution of collateral management technology are discussed below. Figure 3 below represents a future state collateral management platform highlighting the probable impacted areas.

Increase Efficiency Using STP model

Firms should automate components of the collateral management lifecycle ranging from margin calculation to the settlement of collateral between counterparties.

Currently, the low penetration of straight-through processing (STP) is due to the complexity in the processes involved — from origination to settlement. STP can be achieved by using automated collateral transaction processing and through the use of global and common standards such as SWIFT.

Firms attempting an STP model must consider the following:

Source: Company Reports, IMF Staff calculations.Figure 2

Collateral Received that Is Permitted to be Pledged at Large U.S. Banks(November 2007–December 2009; in billions of U.S. dollars)

0100200300400500600700800900

1000

Bear Stearns Lehman Goldman Sachs

JP Morgan CitgroupMerrill/BoA

Rehypothecation Declined During the Recent Crisis

Nov-07 Nov-08 Sep-09 Dec-09

MorganStanley

cognizant 20-20 insights 5

• Standardized electronic messaging: Instead of phone/fax/e-mail channels, the use of secured and fast electronic messaging can transform the way margin calls are managed. It can automate the settlement process, reducing risk and freeing up time to focus on failures and breaks identified in a transac-tion. This increases the operational efficiency of executing collateral management transac-tions since electronic messaging makes the exchange of information transparent and less ambiguous between the counterparties.

• Automated margin calculation/validation and settlement: Each margin call should be subject to predefined STP margin rules. The counterparty can agree to or dispute the margin call and provide its response using electronic messaging.

• Optimized collateral allocation: An automated and analytic engine is required, which allocates collateral optimally as discussed in the “Impact on Collateral Management” section earlier in this paper.

Reducing Credit Exposure (Sequencing of Security Movements)

A proper synchronization of security movements can significantly reduce the credit exposure. The system should make the best effort to execute a security movement that returns cash/credit back to the collateral giver before processing a security movement that draws the giver’s credit line. This helps reduce the overall credit exposure.

Integrated Collateral Management

For historical reasons, collateral management has been perceived as a back-office activity with the

Source: Cognizant Figure 3

Future State Collateral Management Platform

LegendImpacted process(Changed/New)

Repo Treasury Derivatives

Message Gateway

Messaging & Validation Layer

Mes

sag

ing

Lay

er Determine Available Securities

Settlement Instructions

Reporting layer

Sta

nd

ard

Mes

sag

ing

& v

alid

atio

n la

yer

Security Movements

Asset Positions

CCP’s

Securities Lending

Collateral Substitution

Change in Txn amount

Integrated Collateral Allocation Rules Engine (across products and collateral movement triggers)

Transaction Start/End

Priority Order

Collateral Allocation

Margin Calculation Fail Curing

Collateral Reuse

Generate Settlement Instructions

Synchronization of Security Movements

Reporting Module• Margin Report• Exceptions Report• Portfolio Reconciliation Report• Internal Reports

Dispute Management System

• Portfolio Reconciliation System

• Dispute Resolution

• Real-time View of Margin Calls

• Stand-alone Modules, Easily Integrated

Contract InformationSettlement

Messages

(Real time)

Settlement System

Depository/Cross-Border Link

Eligibility Criteria

Online Reports

Mobile Devices

Third- Party Reports

Report Data Feeds

Real-timeAsset Positions

Reference Data

• Security Price

• Corporate Actions

• Counterparty Data

• Credit Rating

cognizant 20-20 insights 6

focus on risk management. It developed in silos at most banks with separate teams for repos, securi-ties lending, derivatives and funds (see Figure 4).

Hence, there is limited integration between collateral management functions within a bank, leading to multiple systems dealing with collateral trades, a fragmented view of the asset inventory and needless manual intervention.

An integrated collateral management solution can enable the firm to view and manage collateral inventory and obligations on an enterprise-wide basis and across product lines — and possibly across business lines and geographies — with increased efficiency. Removing internal fragmen-tation can also help the participants reduce oper-ational costs by virtue of better utilization of the collateral available. This reduces dependency on market borrowings. Firms attempting consolida-tion must consider the following:

• Ensure consistency, standardization of data and infrastructure across the product lines.

• Harmonize the operating model and best practices across product groups.

• Ensure local regulation and tax structure are followed if assets are spread across geogra-phies.

Cross-Border Links

Some global CSDs have already deployed solutions that allow market participants to access collateral across borders (e.g., Euroclear’s planned “Collateral Highway”). For firms that would like to develop this service, the three top priorities from a technology perspective are:

• Manage a collateral giver’s pool across mul-tiple depositories: The collateral management system should be able to:

> Detect unused collateral in a collateral giver’s account with an agent/depository based on the eligibility rules submitted by the giver.

> Generate instructions to move it to the giver’s account with another depository (in a different geography). This may involve generating cross-border instructions from a giver’s account with one agent to the om-nibus account of the agent with another depository. Additionally, in case of likely or pending corporate events, such movements should be avoided or rolled back.

• Frequent synchronization mechanism: There should henceforth be a mirroring mechanism to synchronize the security balances between the accounts of a collateral giver with all the agents/depositories. The balances should be updated both at a CG account level and at the omnibus account level of one agent/depository with another. As real-time synchronization between two cross-geographic depositories is a challenge, the process should occur at the start/end of day and at an agreed frequency intraday.

• Establishing standard communication links (e.g., SWIFT): This is absolutely necessary between the market participants like deposi-tories, settlement agents and cash corre-spondents. The link should allow sharing of mirroring and settlement instructions between the giver’s account, parameters for transfer-

Source: Cognizant Figure 4

Repo

Treasury

Derivatives

Operations

Pro

du

ct L

ines

Equity Cash CommoditiesOTC

DerivativesForeign

ExchangeFixed

Income

SecuritiesLending

Legal Docs•GMRA

•ISDA

•CSA

•MNA

Collateral Management in Silos

cognizant 20-20 insights 7

ring collateral and communicating with agents/depositories.

Dispute Resolution System

A dispute resolution system (DRS) is becoming a strong selling point for collateral management solutions. Counterparties can have a dispute over a collateral call typically due to an underlying trade being missed by either counterparty or dif-ferences in the trade valuation philosophy. A DRS should comprise the following features:

• Odds-based portfolio reconciliation: Regular reconciliations outside the dispute cycle are required to identify potential disputes early. In the case of complex trades, reconciliation can involve market experts and can be expensive. Hence, it is important to take into account the probability of default and focus on the most suspect counterparties such as counterparties with a suspicious credit history or counterpar-ties not using the same data formats.

• An automated end-to-end dispute resolution mechanism: In the event a dispute arises, a meticulous reconciliation of both counterpar-ties’ views of the contract, trade and valuations is required. A real-time view of the margin calls should be available. The Credit Support Annex (CSA) in ISDA lays out rules for settlement of disputes arising from valuation differences and is the most commonly followed. These rules should be implemented by a DRS.

However, it is not just the confirmation of the reason for the dispute but the actual resolution of the dispute by getting trades rebooked and revalued that differentiates a fully automated dispute resolution system from others. Work-flow tools are required to manage the time-consuming process of actually resolving those differences.

• Real-time view: A real-time view of all active margin calls and their status via an Internet portal is also a necessary feature to prevent disputes arising due to asymmetric information.

Reporting Infrastructure Upgrade

Collateral management firms are looking to build a robust reporting infrastructure that is user friendly and easily customizable. The reporting engine should be able to fetch the data both on a real-time and on a periodic basis as required by the end user. Participants are now looking to provide reports through new channels such as Web interfaces and mobile devices in addition to the existing proprietary receiving channels of their clients. This requires integrating the reporting data into a common enterprise-level information layer. The multiple channels can then fetch data from a common source to ensure consistent infor-mation is reported through the various channels and to various stakeholders such as clients, regulatory bodies and depositories.

ConclusionCollateral management provides a new revenue opportunity for custodians, clearing houses and broker-dealers holding a large amount of collateral. They stand to benefit by optimizing collateral usage. They can also offer collateral management as a service to their clients to dif-ferentiate their main product offering from that of their competitors. Change will be consistent in the current regulatory landscape and more so as trade boundaries continue to blur. A strategic approach to IT rather than a set of tactical solutions is required in the emerging environ-ment. An analytically advanced technology platform with an integrated view across asset classes and capable of handling cross-border transactions will be the key enabler in such a case. A well modularized system based on sound architectural principles will enable handling the changes more efficiently. This will ensure that available collateral is optimized across market and asset classes, so that an exposure can be covered in the most cost-effective manner.

References• McKinsey working paper on risk, Number 25: “Assessing and Addressing the Implications of New

Financial Regulations for the U.S. Banking Industry.”

• “Key Data Elements to Achieve Dodd-Frank Compliance,” Ernst & Young.

• “Collateral Management: Beyond the Crunch,” Rule Financial.

• “CME To Roll Out Cross-Margining,” by: Kentz, Mike, Compliance Reporter, 15295699, 10/7/2011. Database: Business Source Corporate Plus.

Footnote 1 Manmohan Singh and James Aitken, “Monetary and Capital Markets Department — The (Sizable) Role of

Re-hypothecation in the Shadow Banking System,” IMF Working Paper, July 2010.

About CognizantCognizant (NASDAQ: CTSH) is a leading provider of information technology, consulting, and business process out-sourcing services, dedicated to helping the world’s leading companies build stronger businesses. Headquartered in Teaneck, New Jersey (U.S.), Cognizant combines a passion for client satisfaction, technology innovation, deep industry and business process expertise, and a global, collaborative workforce that embodies the future of work. With over 50 delivery centers worldwide and approximately 162,700 employees as of March 31, 2013, Cognizant is a member of the NASDAQ-100, the S&P 500, the Forbes Global 2000, and the Fortune 500 and is ranked among the top performing and fastest growing companies in the world. Visit us online at www.cognizant.com or follow us on Twitter: Cognizant.

World Headquarters500 Frank W. Burr Blvd.Teaneck, NJ 07666 USAPhone: +1 201 801 0233Fax: +1 201 801 0243Toll Free: +1 888 937 3277Email: inquiry@cognizant.com

European Headquarters1 Kingdom StreetPaddington CentralLondon W2 6BDPhone: +44 (0) 20 7297 7600Fax: +44 (0) 20 7121 0102Email: infouk@cognizant.com

India Operations Headquarters#5/535, Old Mahabalipuram RoadOkkiyam Pettai, ThoraipakkamChennai, 600 096 IndiaPhone: +91 (0) 44 4209 6000Fax: +91 (0) 44 4209 6060Email: inquiryindia@cognizant.com

© Copyright 2013, Cognizant. All rights reserved. No part of this document may be reproduced, stored in a retrieval system, transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the express written permission from Cognizant. The information contained herein is subject to change without notice. All other trademarks mentioned herein are the property of their respective owners.

About the AuthorsSaugata Chaudhuri is a Consulting Manager in Cognizant’s Business Consulting Group. He has over 10 years of experience in investment management, securities services, private banking and asset and wealth management. He has executed several strategic engagements in the collateral management space for leading depositories to create and deliver service innovations to their clients. He can be reached at Saugata.Chaudhuri@cognizant.com.

Ras Bihari Singh is a Senior Consultant within the Cognizant Business Consulting Group’s Banking and Financial Services Practice. He has seven years of experience in the capital markets domain with knowledge in collateral management, trade settlement and asset-based securitization. He can be reached at RasBihari.Singh@cognizant.com.

Kausik Mondal is a Senior Consultant within the Cognizant Business Consulting Group’s Banking and Financial Services Practice. He has eight years of experience in IT and has worked primarily in the capital markets domain with knowledge in collateral management and trade settlement. His areas of interest include business analysis, requirements management and gap analysis. He can be reached at Kausik.Mondal@cognizant.com.

• “Basel III: International Framework for Liquidity Risk Measurement, Standards and Monitoring,” Basel Committee on Banking Supervision, December 2010.

• “The New Basel III Framework: Navigating Changes in Bank Capital Management,” A publication (October 2010) of PwC’s Financial Services Institute (FSI).

• “Basel III and Its Consequences: Confronting a New Regulatory Environment,” by Michael Auer, Georg von Pfoestl, Jacek Kochanowicz; Accenture.

• “More than Ever, Collateral Management Is Central to Regulatory Compliance and Commercial Success,” Capco.

• BFS_SET_Regulation_Dodd_Frank_1, Cognizant Business Consulting.

• The Journal of Finance • Vol. LXVI, No. 2 • April 2011, “Bankruptcy and the Collateral Channel,” by Efraim Benmelech and Nittai K. Bergman.

• “The (Sizable) Role of Re-hypothecation in the Shadow Banking System,” Manmohan Singh and James Aitken, International Monetary Fund, July 2010.

• “Is Collateral Becoming Scarce? Evidence for the Euro Area,” Anouk Levels and Jeannette Capel, De Nederlandsche Bank: Occasional Studies, Vol.10/No.1 – 2012.

• “Collateral Dispute Resolution – Reconcile Your Differences,” Cubematch.

• “Euroclear-Collateral-Clearing-CCP-CSD-OTC,” Securities Technology Monitor.

• “What Comes Next for Collateral Management: Results from the 2010 SunGard/Finadium Survey,” September 2010.

• One Minute Guide: EU Regulation on OTC Derivatives (EMIR), by Financial Service Authority, UK.

• “Reshaping the Collateral Landscape,” J.P. Morgan Thought / Fall 2012.