Collateralized trading is on the rise. Over the next several years, regulatory mandates for a shift to central clearing and more stringent bilateral trading rules will increase the demand for high quality collateral.
While cash collateral is still king for bilateral OTC derivatives variation margin, market participants are likely to increasingly post securities for mandatory initial margin requirements. Meanwhile, margin call volume is expected to rise many times over—by some estimates as much as 1000%. The growing demand for a limited supply of high-grade collateral will likely increase its cost, which will test the operational capacity of many firms and their ability to manage collateral efficiently.
Mandatory initial and variation margin requirements fundamentally change every aspect of margin processing, including documentation, calculation, dispute resolution, segregation, operations, and technology. As a result, collateralized trading has become more expensive and operationally complex.
Top financial services executives now look to proactively manage their collateral assets as a means of reducing risk, boosting liquidity, and maximizing regulatory capital in an increasingly interconnected industry. To do so, they may need to realign their organizational structures to focus more on collateral optimization.
Increased margin activity and collateral demand will likewise require higher levels of automation. The financial services industry is expected to invest more than $53 billion in technology and infrastructure to address clearing and collateralization inefficiencies in the short to medium term. The forces driving this change transcend organizational silos, underscoring the need for enterprise-wide solutions that provide a common, cross-product view of collateral and are integrated across functions.
Optimizing collateral use has implications for liquidity management across a firm and can help improve risk management in many areas as well. For example, some leading firms are now able to match sources and uses of liquidity by linking returns on assets with cost of funding. They are also factoring in regulatory limits on rehypothecation of collateral assets, which can shorten collateral chains and reduce liquidity.
The difficulties of managing collateral are not specific to a single firm; they cut across the entire financial services industry. Different types of financial institutions may face different trading and operational challenges, but without collaborative collateral solutions, they are likely to share the consequences of failure. To succeed, firms must work together to create a cohesive process that takes into account all the pieces of the collateral ecosystem.
Industry participants expect collateral management utilities and other shared services to emerge that will address core functions such as calculation of initial and variation margin, dispute management, master document management, and collateral tracking, reporting, and optimization. In fact, a number of such utilities are in the planning stages, not least because impending implementation of bilateral margining rules spur the need for a shared industry solution.
However, to get the most value from both their internal and external investments—as well as to maximize liquidity, minimize risk, and achieve regulatory compliance—financial institutions need to take the right approach. We believe that organizations need a comprehensive, robust, operationally integrated, and technologically advanced solution for enterprise-wide collateral management. Implementing such a solution may be crucial to keeping an organization competitive.
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Global Financial Services Leader, PwC US
Principal, PwC US
Director, PwC US
Manager, PwC US