The credit crisis of 2008 brought to the spotlight two types of risks that banks had clearly failed to quantify and control sufficiently: liquidity risk and credit risk. Post-2008, the advent of new regulations has given unprecedented attention to one section of an investment bank: collateral management. Collateral management is a term used by modern financial institutions as a credit risk reduction measure when making a transaction settlement that is unsecured. In traditional banking, collateral is used as an insurance policy by the lender when making a credit over-the-counter (OTC) transaction. However, modern banking has given rise to new technologies, products and internal competition between institutions to innovate and widen the scope of collateral or insurance that can be used. The resultant effect is that collateral went from being a largely cash vehicle to something that now gets exchanged in securities, asset pools, leases, art etc.
Uses of collateral management in today’s financial institution:
The use of collateral is used to benefit both the lender and the borrower in the transaction. For the lender, it offers a clear risk mitigation instrument wherein the impact of default is minimized. But today’s banks now also use it as a balance sheet management technique where excess, underutilized assets on the balance sheet are lent out to counter-parties, enabling a return on them to be earned where previously, they would lie dormant. This has enabled these institutions to optimize capital and earn extra non-core operational income. For the borrower, it represents an opportunity to enhance their credit profile in order to receive a lower bank rate or other such borrowing benefits. Furthermore, when there is a tri-party collateral transaction settlement, there is also an arbitrage opportunity between the borrowers when mispricing exists in the market. The main takeaway here is that the reason collateral management has swollen to become a EUR 2 trillion industry (BNP Paribas) is because of the obvious capital optimization, arbitrage and borrowing benefits that are present when institutions exchange securities by posting collateral.
Key trends in collateral management:
Given the size and growth of the industry, it is pertinent to identify some key trends that may shape the transaction settlement landscape as we know it a few years from now. One major trend that is likely to see exponential growth is the concept of tri party arrangements. In a tri party, there are two counterparties to the transaction and then a third-party agent that manages the transaction collateral. This is particularly advantageous as institutions can now reduce fragmentation and get access to liquidity pools. The Dodd-Frank and Emir regulations have spawned an environment where OTC derivatives have to mandatorily be cleared, giving rise to the need for eligible collateral to reduce credit risk of derivative transactions. In interbank transactions, this has meant that collateral is now a vital cog in mitigating risks across repos, securities lending and secured loans – contributing directly to the growth of tri party collateral management.
Other major trends awaiting to potentially disrupt the market are the advent of financial technology, including, but not limited to blockchain. The blockchain offers obvious tangible advantages through the decentralized ledger and the real-time nature of each transaction. Coupled with its traceability and speed, there is ample room for blockchain to make its niche in collateral processing provided it won’t an expensive technology. On that same note, automated collateral management processes provide an opportunity for real time collateral valuation – an asset worth its weight in gold in stressed markets. The automated nature would also generate automatic, real time margin calls that are settled intraday instead of the current T+1 convention.
As investment banks expand their collateral management treasury desks, there are various variables driving the underlying product’s growth. While its value to lenders and borrowers alike is unquestionable, there are catalysts on the horizon in the form of product innovation opportunities and technological advances that can both increase the efficiency of transactions and reduce institutional credit risks progressively.