Not a game of chance - PwC · operational, and settlement risks. Comply with regulations aiming to make markets more transparent, resilient, and less reliant on central bank funding

When trading,financial firms mustapply greater focuson collateral. Howcan they make themost of theirresources?

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Point of view AppendixA framework for responseCompetitive intelligence

The case for stronger collateral management

Not a game of chance:

FS Viewpoint1

Executive summary

C-Level executives in anincreasingly interconnectedfinancial services industry willfocus on collateral as proactivemanagement of these assetsreduces risk, increasesliquidity, and improvesregulatory capital.

1 Celent, "Maximizing Collateral Advantage: A Survey of Buy Side Business and OperationalStrategies," May 2013.

2 Proactive management of risk, regulation, and capital is arguably the most important of the sixpriorities we cite in our report, “Capital Markets 2020,” for firms looking to stay in the forefrontover the next five years. PwC, “Capital Markets 2020: Will it change for good?” www.pwc.com.

Collateralized trading is on the rise.

Over the next several years, the shift to centralclearing and more stringent bilateral tradingrules is expected to increase margin callvolume exponentially.

While cash collateral is still king for bilateralover-the-counter (OTC) derivatives variationmargin, market participants are likely toincreasingly post securities for mandatoryinitial margin requirements. Meanwhile, a slewof new regulations require firms to hold andpost high-grade collateral.

Growing demand for a limited supply ofhigh-grade collateral will likely increaseits cost.

The result will be more pressure on managersto achieve clear, tangible return on investmentfrom collateral use. To do so, they may need torealign their organizational structures to focusmore on collateral optimization.

Increased margin activity and collateraldemand will likewise require higher levels ofautomation. The financial services industry isexpected to invest more than $53 billion intechnology and infrastructure to addressclearing and collateralization inefficiencies inthe short to medium term.1

However, to get the most value from theirinvestment—as well as maximize liquidity,minimize risk, and achieve regulatorycompliance—financial institutions need to takethe right approach.

We believe that organizations need acomprehensive, robust, operationallyintegrated, and technologically advancedsolution for enterprise-wide collateralmanagement. Implementing such a solutionmay be crucial to keeping an organizationcompetitive—particularly if it is part of aproactive approach to managing risk,regulation, and capital.2

Not a game of chance: The case for stronger collateral management

Focus on liquidity asincreased capitalrequirements andmandated trade clearingwill demand significantamounts of capital.

Better manage credit,operational, andsettlement risks.

Comply with regulationsaiming to make marketsmore transparent, resilient,and less reliant on centralbank funding.

The case for collateralmanagement


Improve liquidity asincreased margin, capital,and segregationrequirements demandhigh amounts of capital.

Focus on liquidity asincreased capitalrequirements andmandated trade clearingwill demand significantamounts of capital.


Comply with regulationsaiming to make marketsmore transparent, resilient,and less reliant on centralbank funding.

The case for collateralmanagement


Improve liquidity asincreased margin, capital,and segregationrequirements demandhigh amounts of capital.

Point of view

FS Viewpoint | Point of view3

1 International Swaps and Derivatives Association (ISDA), "Margin Survey," June 2013.

2 Bank of England, “OTC Derivatives Reform and Collateral Demand Impact”, October 2012.

3 Celent, "Maximizing Collateral Advantage: A Survey of Buy Side Business and OperationalStrategies," May 2013.

4 Depository Trust & Clearing Corporation, “Trends, Risks and Opportunities in CollateralManagement,” January 2014.

5 International Monetary Fund, “The Changing Collateral Space,” January 2013.


Collateralized trading by the numbers

78.3%of collateral is cash

Cash is still king, but marketparticipants are likely to postmore non-cash collateral as

interest rates increase.1

$130 bn+incremental trading

collateral

Estimates show that firmsmay need between $130bn

and $450bn in additionalcollateral to meet higher

initial margin requirementsfor trading interest rate and

credit default swaps. 2

$53 bntechnology

investments

The financial services industryis expected to invest over$53bn in technology andinfrastructure to address

inefficiencies in the clearingand collateralization

environment. 3

1000%Increase in margin

calls

Stronger collateralrequirements could increase

margin call activity by as muchas 1000%, adding to risk andimpacting firms’ operational

capacity. 4

$2-$4 tadditional collateral

New banking safety rules thatrequire firms to hold a greaterproportion of cash and easy-to-liquidate investments willcreate a demand for $2-$4trillion additional collateral. 5


New rules and newdemands are challengingplayers in new ways. It’sa new game for collateralmanagement—andfinding the rightapproach to deal withthese challenges andopportunities is now amake-or-breakproposition.

Global regulation is increasing thedemand for collateral, changing supplydynamics and ultimately makingcollateral the lingua franca of capitalmarkets.

While cash still constitutes roughly 75% of thetotal collateral value underpinning un-clearedover-the-counter (OTC) derivativetransactions, this can change.1 Regulatorymandates (Basel III, global financialregulators, and WGMR, the Working Group onMargin Requirements) will both increase thedemand for high-quality collateral for centrallycleared, bilateral derivatives trading, as well asleverage ratios.

Meanwhile, margin call volume is expected torise many times over—by some estimates, asmuch as 1,000%—which will test theoperational capacity of many firms and theirability to manage collateral efficiently. 2

Collateral can no longer be an afterthoughtwhen trading, as more stringent demandsincrease costs and, therefore, require a real-time understanding of collateral implicationsprior to execution.

The number of collateral delivery channels isgrowing, and with it the need to assess andmanage delivery strategically and efficiently.Financial institutions are implementing moreadvanced trade analytics to identify optimaltrading venues, with collateral as a criticalcomponent of the analysis.

In our view, the forces driving this changetranscend organizational silos, underscoringthe need for enterprise-wide solutions thatprovide a common, cross-product view ofcollateral and are integrated across functions.


What is collateral managementand why does it matter?

Whether lending or trading, collateral hashistorically been exchanged to mitigatecounterparty risk. However, as regulatorymandates have intensified and efforts toimprove liquidity and manage risk havedeepened, collateral management hasassumed greater prominence inorganizations on both sides of the street.

Ultimately, collateral management focuseson developing the processes and supportingtechnologies to ensure that the assets used tomeet regulation and manage risk alsopromote liquidity and maximize return oninvestment.

1 International Swaps and Derivatives Association (ISDA),"Margin Survey," June 2013.

2 Depository Trust & Clearing Corporation, “Trends, Risks andOpportunities in Collateral Management,” January 2014.


A deluge of changes—mandatory tradeclearing, stricter capitalrequirements, andprescriptive bilateralmargin rules, amongothers—have amplifiedthe role of collateralmanagement in capitalmarkets.

New regulations aim to make markets more transparent, resilient, and less relianton central bank funding, while imposing changes unprecedented in scope.Regulatory changes have affected many different securities markets (see Figure 1):

• Introduction of central counterparties (CCPs)—Dodd-Frank in the United States, as wellas its European and Asian equivalents, require central clearing of many OTC derivatives;voluntary clearing of repo and securities lending transactions is also gaining traction.

• Higher capital requirements—Basel III and other new regulations have raised riskweightings for un-cleared and/or un-collateralized trades.

• New margin requirements—For both bilateral and cleared trades, new requirements areleading to an increased focus on internal allocation of collateral across a firm’s businessactivities.

Mandatory initial and variation margin requirements fundamentally change every aspect ofmargin processing, including documentation, calculation, dispute resolution, segregation,operations, and technology. As a result, collateralized trading has become more expensive andoperationally complex.


Figure 1: Impact of regulatory drivers on various types of collateralized products.

Themes OTC swaps Repurchaseagreements

Securitieslending

Foreignexchange

Listedderivatives

Re

gu

lato

ryre

qu

ire

me

nt

Central clearing

Increased capitalrequirements

Multilateral tradeexecution

Portfolio reconciliation

Reporting

Financial transactiontax

Bankruptcy/liquidationmitigation

Degree of impact

Very high LowHigh Medium


Optimizing collateral usehas implications forliquidity managementacross a firm and can helpimprove risk managementin many areas, as well.

The inextricable linkage betweenliquidity and collateral means that firmsneed to manage risk while alsomaximizing liquidity (see Figure 2).

Leading firms are:

• Creating an enterprise-wide collateralinventory across product silos.

• Prioritizing the use of idle assets over cashand cash-like collateral.

• Matching sources and uses of liquidity bylinking returns on assets with cost of funding.

• Factoring in regulatory limits onrehypothecation of collateral assets, whichcan shorten collateral chains and reduceliquidity.

• Providing greater visibility into commoncollateral pools across the organization.

Heightened expectations formanagement of credit, operational, andsettlement risks—from regulators,shareholders, and the public—are alsodriving firms to improve collateralmanagement.

Leading firms are:

• Standardizing collateral managementpractices across legal, credit, sales, middle,and back offices. This can includeautomation of collateral operations tosupport more real-time, aggregatedreporting—a step that also enables moreproactive management of counterparty,credit, and operational risk.

• Implementing advanced risk and creditframeworks for credit-value adjustment(CVA), which capture volatility in derivativecounterparty risk.

• Protecting collateral assets through improvedtracking and segregation of collateral use,which improves trade portability.

• Standardizing trade agreement documents tosupport transactions with CCPs, clearingbrokers, and market utilities.

• Gaining a better understanding of enterpriserisk through improved stress-test simulationand master-agreement management.


Figure 2: Impact of liquidity and risk management on various types of collateralized products.

Themes OTC swaps Repurchaseagreements

Securitieslending

Foreignexchanges

Listedderivatives

Liq

uid

ity

ma

na

ge

me

nt Demand for high-

grade collateral

Tri-partyinfrastructure reform

Ris

km

an

ag

em

ent Documentation

revolution

Collateralprotection/portability

Markettransparency

Degree of impact

Very high LowHigh Medium


Different types offinancial institutions facedifferent trading andoperational challenges—but without collaborativecollateral solutions, theyare likely to share theconsequences of failure.

The difficulties of managing collateral are not specific to a single firm; they cutacross the entire financial services industry. To succeed, firms must work together tocreate a cohesive process that accounts for all pieces of the collateral ecosystem.


Sell side At sell-side firms, Basel III, Dodd-Frank, EMIR, and the Volker rule have forced a re-examination—and in some cases, dislocation—of core businesses. Collateral, clearing, andliquidity are converging, requiring integrated, global operating models and technology. At the sametime, revenues are declining and regulation is making operations more complex, triggering a drivefor organizational efficiencies.

As a result, sell-side firms are seeking to optimize trade processes, increase operational efficiency,reduce costs, and develop a holistic view of counterparties across products and geographies.

Buy side Many buy-side firms see a direct or indirect impact from trade clearing and/or bilateral OTC swapmargining rules, resulting in fundamental changes in operations. Rising margin calls andcompliance requirements demand automated solutions, whether developed in-house oroutsourced.

As a result, leading buy-side firms are working to realize cross-product margining opportunities,develop analytics to drive margin efficiencies, and move their manual, spreadsheet-based tools toa more automated and compliant collateral management infrastructure.

Custodybanks

Custody banks look to sell enhanced custody and liquidity services over the full trade lifecycle toboth the buy-side and the sell-side. These organizations must determine how to provide seamlessdelivery, so that their customers will prefer these services over in-house management ofincreasingly complex collateral operations.

As a result, leading custody banks are working on improving the client experience, providingsolutions that are truly global and cross product, and implementing more efficient middle- andback-office collateral management and liquidity solutions.

Clearingmembers

Clearing members face a dramatic rise in clearing costs due to new capital and collateralrequirements, transforming clearing and forcing a re-evaluation of the business itself. The exit ofsome providers from the business can lead to unintended risk concentration, as well as issues withporting of positions and assets to surviving providers in the event of a default. Operational burdensare also increasing, including near-real-time trade acceptance, collateral segregation, and morerobust compliance.

As a result, leading clearing firms are working to bundle clearing with other offerings to strengthentheir profitability and ensure viability. The changing business model is exacerbating the increasedoperational complexity and required investment in technology brought on by financial regulations.


Creative solutions thatemploy collaborativealliances will address theregulatory, risk, andliquidity demands oftoday and tomorrow.

Market utilities include centralcounterparties and trade data repositories, aswell as providers of trade compression,portfolio reconciliation, electronic messaging,collateral settlement, dispute management,and collateral outsourcing. This diverse groupis central to market function, as participantsseek liquidity benefits and operationalefficiency.

Industry participants expect collateralmanagement utilities and other shared servicesto emerge that will address core functions,such as calculation of initial and variationmargin, dispute management, masterdocument management, and collateraltracking, reporting, and optimization. In fact, anumber of such utilities are in the planningstages, not least because impendingimplementation of the WGMR bilateralmargining rules spur the need for a sharedindustry solution.

A shared market infrastructure can speedregulatory compliance and promoteoperational and capital efficiencies by usingstandard methods to connect with vendors andreducing operational risk via automation.

However, these utilities face many challenges,including competition among marketinfrastructure providers, delays in regulatoryapproval, and the need to integrate withinternal and external offerings. In addition,utilities must work to seamlessly connect andexchange real-time data with diverseparticipants in the trade lifecycle and collateralchain.

Industry groups such as ISDA, the SecuritiesIndustry and Financial Markets Association(SIFMA), and the Futures Industry Association(FIA) are focused on shaping and clarifyingregulation while leading and coordinating theindustry response. The challenges for theseorganizations include anticipating andinterpreting regulatory changes; developingunified, industry-wide responses that satisfydiverse participants with different needs; andeducating regulators about possibleunintended consequences of their actions.

As is the case with other market participants,the accelerating pace of regulatory change is anissue for industry groups, which must facilitateleading practice recommendations to meet newrequirements while working with participantsand regulators to assess and implement newrules.

Product vendors offer enterprise solutionsthat provide an alternative to outsourcing andproprietary approaches. They are popular withlarge sell-side firms as well as many buy-sideparticipants, but also face an increasinglycompetitive field and must invest in researchand development to keep pace with clientneeds and regulatory changes.

Vendors face additional issues, such asdeveloping modular solutions that crossproduct lines yet can still be used as pointsolutions; creating simple, repeatablemigration processes that enable clients todeploy rapidly; and allowing clients tocustomize solutions while still ensuring thatthey can accept new releases readily.



We’ve created a comprehensivecollateral management frameworkbased on the practices of leading firmsfrom both sides of the street. We call thisapproach the “five ‘tions’ plus one.”

To improve regulatory compliance, liquidity, and riskmanagement, organizations need a comprehensive collateralmanagement framework.

Although each area is important in its own right, the interrelationbetween them is critical to achieving a holistic solution. Our approachoutlines the critical components of a successful collateral managementprogram.

Not a game of chance: The case for stronger collateral management9

Asset segregation supports market confidenceby protecting assets and providing transparencyinto the use and re-use of client collateral.Market participants have access to severalsegregation models to support the best fit withthe desired risk profile.

Mobilization entails identifying,sourcing, optimizing, transforming,and deploying collateral acrossdifferent organizational divisionsand locations. A natural companionto optimization, it enables collateralmovement to the right place at theright time.

Optimization involves raising the greatestamount of cash from available securities whileminimizing funding costs. It enables marketparticipants to efficiently allocate assets againstregulatory, liquidity, risk, legal, and operationalconstraints.

Documentation formalizes the terms of a contractbetween two transacting parties. Previously,documentation focused primarily on mitigatingcounterparty credit risk; now, it is required tomeet regulatory mandates while also providing apossible source of latent liquidity.

Automation is key to efficient marketparticipation and achievingregulatory compliance. Institutionsshould consider achieving a greaterdegree of automation byimplementing straight-throughprocessing (STP) workflows andelectronic messaging.

Transformation entails the exchange of lower-grade collateral for higher-grade collateral throughrepo and securities lending markets. Whensourcing collateral for OTC trades, it could be apotentially expensive but effective avenue foracquiring the high-grade collateral needed fortrading.

6 componentsof a successful

collateralmanagement

program

Segregation Documentation

AutomationMobilization

Optimization Transformation


Our approach can yield anumber of regulatory,liquidity, and risk benefitsacross a range of areas.

The five “tions”plus one

Regulatory, liquidity, and risk benefits

Documentation • A prerequisite for accessing central clearing, electronic execution platforms,bilateral OTC swaps trading, and TBA margining, documentation enables assetsegregation protection through Account Control Agreements.

• Reduces counterparty credit risk through documentation of default protocols,provides a consistent view of risk to inform trading decisions, and promotes assetportability in case of credit events.

• Reduces collateral optionality by promoting trade valuation consistency, andmobilizes collateral globally by establishing relationships and documentingagreements with market utilities that support broader market access.

Automation • Enables collateral inventory aggregation, optimization, mobilization, andsegregation.

• Provides efficient management of trade files, margin calls, substitutions, settlementstatus monitoring, fails, position reconciliation, and disputes.

• Allows market participants to improve efficiency, reduce operational risks, andredeploy staff to focus on higher value activities.

Transformation • Provides an avenue for acquiring the high-grade collateral needed for trading.

• Mitigates potential collateral crunch (along with cross-product margining, broadercollateral eligibility, and compression).

Optimization • Reduces the need for transformation.

• Exploits latent liquidity.

• Enables repositioning of collateral operations from a cost center to a revenuegenerator.

• Allows market participants to allocate assets efficiently against regulatory, liquidity,risk, legal, and operational constraints.

Mobilization • Improves liquidity, manages cost, mitigates risk, and satisfies greater collateraldemand.

• Overcomes collateral depository fragmentation, enables improved optimization, andincreases funding opportunities.

• Provides increased settlement transparency and certainty, reduces fails, andimproves collateral access across borders.

Segregation • Reduces risk from counterparty default or fraud/misuse, and facilitates porting ofassets and positions after a default.



With clearly articulatedgoals, stakeholder buy-in,and a phasedimplementation roadmap,organizations cantransform their collateralmanagement programs.They must be prepared,however, to address anumber of challenges.

Challenge Potential ways to address challenges

Operating model

Moving collateral from aback-office to a front-officefunction can requiresignificant operating modelchanges, includingintegrating collateralizedtrading desks with treasury,legal, and credit functions.

• Understand how each function uses collateral and how common assetswill be used in the future, considering competing demands from the frontoffice, treasury management, and risk management.

• Determine if creating a centralized collateral function is the bestapproach to address cross-organizational collateral needs.

• Define and implement a stakeholder-approved, cross-functional, andglobal operating model that is flexible enough to meet changingorganizational and regulatory demand.

Technology

A technology approach thatsupports the operatingmodel can be difficult todeliver at a cost that iscommensurate withrevenue.

• Gain control of agreement management, inventory management, andpotentially optimization, including scenario and stress-test analysis.

• Assess time-to-market constraints, such as regulatory deadlines, sincethese largely determine whether a firm builds its own system or uses avendor, outsourced, and/or utility solution.

• Determine if an enterprise collateral management solution isappropriate. Some business heads might prefer “best-of-breed” solutionsthat are more targeted to their specific needs.

Data management

Developing an enterpriseview of assets, in real timeand available to allfunctions of anorganization, will requireimproved datamanagement.

• Create a data architecture that revises or eliminates legacy batch-drivenprocesses to enable real-time management of the asset inventory.

• Develop a data “middle layer” that sources data from relevant systemswhile providing real-time data instead of a central data repository.

• Craft solutions to achieve efficient straight-through processing whilesynchronizing data to permit all users to see the same “version of thetruth.”

Return on investment

Getting bottom-line benefitsfrom a collateralmanagement program maymean transforming thefunction from a cost centerto a profit center.

• Employ utilities to both defray unilateral costs and shift the regulatorycompliance, operations, and technology support burdens to the provider.

• Maintain accurate and consistent data to allow market participants torealize greater yield from each asset, lower the cost of borrowing, andcut back on over-collateralization—while using liquid assets to theirfullest potential.

• Rather than cut headcount, redeploy staff from manual, repetitive tasksto value-add endeavors such as monitoring riskier bilateral tradingcounterparties.



Those who leave collateralmanagement to chancewill not only miss theopportunity to gain acompetitive edge byunlocking liquidity—theyrisk being unable toparticipate in capitalmarkets because theycannot meet theheightened expectationsof regulators and themarketplace.

Like blacksmithing at the advent of theautomobile, it is irrelevant how, or howwell, the function is performed todaybecause it is changing in fundamentalways.

In our view, given the current regulatory,liquidity, and risk management burdens thatfinancial services institutions face, widespreadchanges are needed. Ultimately, theconsequences of not embracing and gettingahead of these changes will be significant:

• Diminished ability to participate in marketactivities—if an institution cannot meet themargin requirements of a centralcounterparty, then it cannot trade.

• Unacceptable exposures to counterpartycredit risk.

• Inability to meet regulatory liquidity ratios,leading to fines, reputational damage, andreduced access to credit markets.

• Increased time in settling trades and meetingmargin calls.

• Reduced capacity to identify and mobilizeeligible collateral effectively.

• Diminished ability to unlock latent liquidity.

• Increased operational costs, due tooperational and technology efficiencies.

• Reliance on expensive, unsecured funding.

The prospect of continued regulatorychanges in the coming yearsunderscores the urgency of takingaction—and of taking the rightcombination of actions to meet thecollateral management challenge.


Competitive intelligence

Our observations ofindustry practices.

FS Viewpoint | Competitive intelligence14

While some firms have invested in collateral management solutions,additional work is needed to thoroughly address regulatory, liquidity,and risk management issues.

Ad hoc Competent Mature

Documentation • Appropriate master documentation coversmost trades and is readily accessible whenneeded.

• Essential (but not all) terms in the masteragreements match those contained incollateral management systems.

• Most documentation processes are manual,including negotiation and input of terms, butwith controls such as “four-eye checks.”

• All master agreement terms are digitized,electronically searchable, and preferably,held in a central repository.

• All master agreement terms match thosecontained in collateral managementsystems.

• All documentation processes are automated,including workflows to negotiate agreementswith counterparties.

• Industry standard master agreements (suchas ISDA) that minimize optionality cover alltrades.

• Firm uses trade data repositories, electronicmessaging, and other shared market utilitiesto aid document management.

• Automated documentation methodsmaintain “one version of the truth” amongthe legal, sales, operational, front-office,credit, and risk management functions.

Automation • A single daily batch exchange of critical dataserves the treasury, trading, credit, risk, andsettlement functions.

• Business lines and systems do not easilyshare data.

• Staff levels that are incompatible withoperational needs increase risk and cost(such as large offshore teams handlingdispute resolution).

• Intra-day exchanges of critical data servethe treasury, trading, credit, risk, andsettlement functions.

• Systems issue margin calls withoutpractitioner intervention.

• Firm redeploys staff from low-value manualtasks to value-add functions.

• Real-time exchange of critical data servestreasury, trading, credit, risk, and settlementfunctions.

• Straight-through processing of workflowsextends across the internal collateralmanagement lifecycle.

• Straight-through processing of workflowsextends to external counterparties, serviceproviders, and utilities.

Transformation • Collateral management lacks internalizationso inventory is not well known or utilized,resulting in expensive externaltransformation trades.

• Firm lacks pre-trade analytics that wouldhelp determine collateral demandproactively.

• Operating model facilitates communicationbetween lines of business to determine bestuse of shared collateral resources.

• Systems provide a common view ofcollateral inventory, as well as limitedoptimization functionality.

• Collateral management achievesinternalization, allowing identification anddeployment of internal assets (otherwisehidden in business-line silos) beforeconsidering outside funding sources.


FS Viewpoint | Competitive intelligence15

While some firms have invested in collateral management solutions,additional work is needed to thoroughly address regulatory, liquidity,and risk management issues (continued).

Ad hoc Competent Mature

Optimization • Firm uses a manual, spreadsheet-basedapproach for ranking collateral inventoryusing a static firm profile for risk appetite andeconomic outlook.

• Methods focus on cheapest-to-delivercollateral.

• Individual product trading desks have limitedview into cross-organizational collateralholdings and available assets.

• Firm takes an algorithmic approach tocollateral ranking based on predeterminedfactors, such as cost, liquidity, and marketvolumes.

• Methods differentiate collateral by ranking,haircut, and location (including costs ofmoving).

• Systems provide a cross-functional,enterprise-wide view of collateral across allasset classes, business lines, andrepositories.

• Specialized collateral trading/CVA desksmanage the firm’s supply and demand.

• Collateral management realizes the greatestpossible yield from each asset, minimizesthe cost of borrowing, eliminates over-collateralization, and ensures that allpotential liquidity is put to work.

• Firm considers optimization beyondcollateral, including cross-product margining,funding, financing/funds-transfer-pricing,liquidity, portfolio, and balance sheet.

Mobilization • Firm sources collateral from a local pool ofcollateral and has limited capacity to locateand transport collateral cross-border.

• Back office uses manual rather thanelectronic methods for collateral agreement,instruction, and settlement.

• Back office tracks and reports collateralholdings manually in batches.

• Systems permit a view of global collateraldata across business lines/globalrepositories to optimally match collateralassets to collateral requirements.

• Automated systems track settled and failedcollateral movements, resulting in improvedforecasting of funding needs.

• Systems seamlessly connect with sharedmarket utilities to transform matches andcalculated margin calls to settlementinstructions; send pledges, transfers, orbilateral instructions to custodians; receiveand record settlement instructions; andreport consolidated collateral activities andpositions across locations and jurisdictions.

Segregation • Back office manually tracks segregatedcollateral held at custodians, centralcounterparties (CCPs), and dealers.

• Systems cannot always differentiatebetween encumbered and unencumberedcollateral.

• Legal and operational difficulties prevent thefirm from using segregation protection forbilateral over-the-counter (OTC) swaps.

• Systems permit automated substitution ofsegregated collateral.

• Collateral management facilitates monitoringof complex portfolios, including support foreligibility, concentration limits, and haircuts.

• Firm achieves operational, legal, andtechnical ability to support varioussegregation models.

• Systems automatically track collateral heldby custodians, CCPs, and dealers and itsrehypothecation.

• Firm selects an optimal segregation modelbased on cost, risk, and jurisdictionalfactors.


A framework for response

Our recommended approachto the issue.

FS Viewpoint | A framework for response17

Institutions need acomprehensive collateralmanagement solution that willhelp them maintain regulatorycompliance while maximizingliquidity and minimizing risk.

To maximize value from finite collateral resources, organizations must take a holisticview. We believe that an effective collateral management program should include sixcritical components: documentation, automation, transformation, optimization,mobilization, and segregation. This approach—the five “tions” plus one—can helpfirms build an operationally integrated and technologically advanced enterprise-widesolution that delivers the regulatory, liquidity, and risk benefits they want.


6 componentsof a successful

collateralmanagement

program

Segregation Documentation

AutomationMobilization

Optimization Transformation


DocumentationEnsure that documentation meets leading practice standardsto achieve regulatory compliance, minimize counterpartycredit risk, and inform trading decisions.

Proper documentation is essential to protecting all participants in collateralized trading.Regulators require it for both cleared and un-cleared trades—which now fall under newbilateral margining rules that can call for independent collateral segregation.Meanwhile, central counterparties (CCPs) have their own documentation requirements,as do other market utilities (including trade data repositories and providers of tradecompression, portfolio reconciliation, electronic messaging, collateral settlement,dispute management, and collateral management outsourcing).

Start by gaining an overall picture of where you now stand and how youultimately want your documentation practices to work.

Getting documentation right

We believe that firms should use boilerplateagreements whenever possible to simplifyoperations and ease negotiation. This isparticularly important in bilateral derivativestrading, where such common industrytemplates as the ISDA standard credit supportannexes (SCSA and SCSA2) do much to removeoptionality by using overnight indexed swaps(OIS) that discount and align collateral andtrading currencies. Whether or not a firm usesthese templates, it should ensure that tradingrelationship master documentation:

• Includes all material terms governing thetrading relationship with counterparties.

• Provides legal certainty for non-centrallycleared derivatives transactions.

• Covers the lifecycle of bilateral over-the-counter (OTC) derivatives from daily marginprocessing, dispute management, and assetsegregation.

• Captures the trading relationship in a “non-writable” and “non-erasable” digital form, soit cannot be altered without consent

It is also important for a firm to gain an overallpicture of both where it now stands and whereit wants to go with its documentation.


Key steps Recommendations

Understand currentstate

• Identify what agreements are in use (Global Master RepurchaseAgreements, ISDA master agreements, Securities LendingAgreements) and how stakeholders from different functions (legal,credit, sales, operations) use them.

• Determine where and how documents are stored, how different usersand systems get the same “version of the truth,” and how agreementsare negotiated, finalized, and updated between stakeholders.

Determine futurestate

• Establish the degree of automation and centralization required tosupport existing agreements.

• Leverage emerging industry utilities to negotiate and store contractterms.

• Explore automated workflow and agreement management storagetools.

• Determine how to simultaneously manage multiple credit supportannexes (cash-only variation margin, cash-only initial margin,securities only variation/initial margin, SCSA/SCSA2).


AutomationImplement straight-throughprocessing to improveoperational efficiency and riskmanagement.

Automation is critical to transforming a firm’s collateral management function, streamlining front-to-back workflow while supporting an effective operating model. Implementing straight-throughprocessing across the collateral management lifecycle leads to operational efficiencies, enhancedliquidity, and improved risk management, while re-allocating back-office staff to higher valueactivities.

However, we believe that before automating, a firm must first establish a cohesive operating modelthat allows for easy sharing of enterprise collateral assets. Automating internal collateralmanagement processes can prove to be difficult, and it is also a challenge to design, build, and testthe complex interfaces needed to connect internal systems to the market. To do so, it is importantfor a firm to prioritize automation initiatives that support profitable market participation.



Assess current state • Document and analyze end-to-end workflows.

• Assess automation opportunities.

Develop and maintaintarget state

• Develop a target-state solution that details the desired workflow.

• Prioritize automation opportunities.

• Align implementation plans with other internal transformation efforts.

• Conduct periodic reviews to ensure new initiatives are consistent with thetarget state.

Leverage industrystandards andinfrastructure

• Accelerate integration efforts and minimize translation costs by usingstandards such as the Financial Products Markup Language and theClearing Connectivity Standard.

• Use shared industry utilities and off-the-shelf vendor packages whereverpossible; concentrate on a robust framework for integrating these solutionswith both internal and external systems upstream and downstream.


TransformationPrepare for an increaseddemand for high-quality liquidcollateral by leveragingcollateral transformation.

While the predicted shortage of high-qualityliquid collateral has yet to materialize—despitethe imposition of central clearing for manyderivatives in the US—it may still happen,particularly after a similar European regulatorymandate goes into full effect. The growingimpact of liquidity coverage ratios may alsointensify demand for high-quality liquidcollateral.

Market participants may need to use thesecurities finance markets for “transformation”trades that turn lower grade securities intohigh-grade “clearing-eligible” paper. In themeantime, banks are currently doing thesetrades to acquire securities that will help themmeet regulatory requirements for liquiditycoverage.

Ultimately, most firms will fall into one of twogroups:

• Firms who have a need for high-gradecollateral—Firms who expect they may needtransformation services in the future shouldlook to partner with providers that offerliquidity in periods of stress.

• Holders of high-grade collateral—Theproviders will include traditionally collateral-rich participants, such as custody banks.Regulations may result in additionalparticipants, such as hedge funds and cash-rich corporations that are entering thetransformation markets to generateadditional revenues. These firms shouldconsider how they can support a potentiallysignificant new business model by lendingtheir collateral for higher returns.


Note: The asset examples shown are illustrative only;actual haircut rates will vary with market conditions.

High-quality liquid assets typicallycarry a low haircut rate.


OptimizationExploit available securitieswhile minimizing borrowingcosts.

The collateral optimization process enables efficient allocation of assets in line with regulatory,liquidity, risk, legal, and operational constraints. More sophisticated than basic “cheapest-to-deliver” (CTD) allocation, optimization exploits available securities while minimizing borrowingcosts. While CTD is sufficient for some participants, banks and dealers must have the ability toview their holdings and disposition of collateral across all asset classes, business lines, andrepositories—including open positions and locations of pledged assets.

We believe that a comprehensive collateral optimization solution should deliver inventorymanagement, collateral tracking, and complex analytics using automation and straight-throughprocessing. It should offer a view of collateral across custodians. It should also link to tri-partycollateral providers, central securities depositories (CSDs), and utilities that allow for the tracking,settlement, status of margin calls, and transparency into the settlement lifecycle.

Getting to such a solution requires a complete picture of the firm’s current practices andagreement on goals.



Understand currentoptimization practices

• Document practices across business silos, including rehypothecationpolicies as well as sources and uses of collateral.

Quantify benefits • Consider revenue lost, funding cost, impact on the balance sheet, andreturn on equity.

• Understand the impact of various interest rates, credit ratings, andspreads.

• Assess internal transfer pricing policies.

Develop targetoperating model

• Implement the model incrementally across business/product silos andgeographies.

• Enable the model using automation.

Optimization goals and objectives

Front office Gain greater control of collateralselection against trades.

Treasury Effective collateral use foradhering to capital requirementsfor collateral, liquidity, andregulatory capital.

Buy side Minimize demand for high-gradeand additional collateral.

End users Manage higher costs from buyingassets in the market solely forcollateral purposes and usingcash as collateral when it couldbe used elsewhere.

Serviceprovider

Provide a differentiator to clientsto win new business andgenerate revenues from existingbusiness.


MobilizationSource, optimize, transform,and deploy collateralregardless of its location.

Mobilization entails moving a firm’s collateral across borders and among repositories, creating avirtual collateral pool across their business lines and geographies. Firms can use services providedby International Central Securities Depositories to use collateral located in one business unit orgeography to settle obligations across the globe, in a relatively fast, cost-effective way. Mobilizationallows participants to cover exposures where and when needed, improving liquidity and mitigatingrisk.


Mobilization benefits

• Single, holistic view of all collateral assets andobligations by creating a virtual global collateralpool across business lines and geographies.

• Real-time global collateral data across businesslines/global repositories to optimally matchcollateral assets to collateral requirements.

• Improved collateral access across borders toreduce liquidity needs and financing costs.

• Improved forecasting of funding needs as a resultof settled/failed collateral movements.

Illustrative mobilization platforms:

• Euroclear Collateral Highway

• Clearstream Liquidity Hub GO

• Eurosystem T2S

Bank A’s collateralheld at custodian

in New York.

Bank A uses a book entryto move collateral from

New York to Luxembourgthrough an industry

provider of mobilizationservices.

Bank A settlestransaction with

Bank B inLuxembourg.

Virtualglobal

collateralpool


SegregationAdopt an asset segregationmodel that offers the properlevel of protection andefficiency.

Demand for collateral segregation services for un-cleared derivatives trades is expected to greatlyincrease as a result of the WGMR’s (Working Group on Margin Requirements) rules, which allowfor both mandatory and optional third-party segregation.

For participants, implementing these rules involves establishing custodian accounts, connecting tocustodians, and moving collateral, as well as negotiating account control agreements (ACAs) andtri-party control agreements. Firms will also need to actively manage valuation and substitutions ofcollateral, integrating these functions effectively into the optimization and segregation process.


Full physicalsegregation

Gross omnibus–legalsegregation with

operationalcommingling (LSOC)

Net omnibus–comparable tofutures model

All collateral goes into one pot, but it isattached to individual clients. Collateral ofnon-defaulting firms should be protected ifthere is no shortfall following a default. Inthe case of a shortfall, US bankruptcy lawrequires recovered amounts to be sharedpro rata among all clients.

Each client gets its own individualcollateral pot, potentially away from thefutures commission merchant (FCM).Theoretically, client collateral should beprotected in all circumstances—evenfollowing a double default of the FCM andanother client. In the US, however,physically segregated accounts can beexposed to loss, barring amendment to thebankruptcy rules or defining clientcollateral so it is not treated as FCMcustomer property.

All collateral goes into one pot, unattachedto individual clients. The clearing housecan draw from the non-defaulter’scollateral before it turns to its own capitalor the default contribution of non-defaultingFCMs.


Segregation (continued)Different participants inthe market will havedifferent challenges andpriorities.

Sell-side: Under proposed margin rules forun-cleared bilateral trades, the industryexpects the number of required segregationaccounts for initial margin will growexponentially by 2019—by some estimates,8,000 new accounts will be required by the endof 2015.1 Further, each dealer will need tointeract with an increasing number ofcustodians, as each may appoint differentcustodians to hold their segregated initialmargin. Establishing new custodialrelationships and building connectivity to each,implementing internal system changes, andimplementing STP will pose significantchallenges.

Buy-side: Asset managers must determinewhich segregation model is appropriate forboth cleared and bilateral trades, weighing thebenefits of risk mitigation versus operationalcomplexity and cost. As is the case with thesell-side, participants will want to track, value,and substitute collateral seamlessly.

Custody banks: Custodians need to scale upin response to the exponential growth indemand for segregation services. This includesproviding STP solutions for both un-clearedand cleared segregation models. Custody banksare likely to see competition from centralsecurities depositories and CCPs.

CCPs: US regulation mandates the LSOCmodel while Europe offers a variety of models,including “full” segregation, under which acustodian or CSD holds the assets. In the US,CCPs can hold excess margin away from theFCM, but they will also need to work withcustodians who offer quad-party segregationmodels to clients and broker dealers.

Central securities depositories (CSDs):EMIR 47.3, a European financial regulation,mandates that CSDs hold initial margin. Whilethis is not a requirement in the US, a CSDcould also offer segregated accounts for bothcleared and bilateral trades.


1 “ISDA letter to the ESAs on estimates of numbers of accountsaffected by IM segregation requirements, to demonstrateoperational challenges,” www2.isda.org, August 22, 2014.

FS Viewpoint | A framework for response

Case study: A leadingbank takes steps to betterdeploy cross-organizational collateraland improve operationalefficiency.

A G14 bank/broker dealer needed help inidentifying opportunities to better integrate arecently formed fixed-income repo and primefinance joint venture. The bank’s disjointedprocesses and technology kept its collateralmanagement function from operating efficientlyand effectively:

• The fractured collateral inventory reducedliquidity and forced the bank to use unsecuredfunding for posted collateral.

• Siloed counterparty views limited the bank’sability to effectively manage concentrationlimits and credit risk.

• Manual tasks plagued the organization,requiring the bank’s employees to spend asignificant amount of time reconcilinginformation on spreadsheets, checking dataintegrity, and performing other transactionalactivities.

• The fixed-income repo and prime financefunctions operated independently, creatingfriction for clients who interacted acrossdivisional lines.

To address these issues, the bank embarked on a12-month journey to improve its collateralmanagement across its fixed-income repo andprime finance functions. First, it merged the twofunctions to meet funding, liquidity, and

efficiency goals. This included co-location of thetrading, liquidity management, and fundingfunctions of the three groups on the same floorto minimize duplicative activities and leverageexisting infrastructure.

Next, the bank aligned operating models andconsolidated operations with a view towardcreating a common supporting technologyplatform. This included redeployment of staff tomore value-add tasks that helped limit theimpact of the consolidation on core businesses.It also implemented tactical modifications toeach function’s technology platform to provide acommon collateral inventory view (eliminatingthe immediate need for a complex commoninventory solution).

Finally, the bank leveraged and reducedcustodian accounts, aligning the settlementfunction and facilitating collateral optimization.

With a relatively modest capital investment, thebank realized measurable results: it had a stableoperational and technical infrastructure, as wellas a culture of cooperation and success thatwould support the more strategic changes itneeded to truly merge and continuously improveits handling of collateral throughout theorganization.

Not a game of chance: The case for stronger collateral managementFS Viewpoint | A framework for response25

Appendix

FS Viewpoint | How PwC can help27

Why PwC? Collateral management transformation is a complex undertaking that requires a trusted partnerfor success. PwC offers an unparalleled set of capabilities, skills, and experiences to help capitalmarkets participants. We can apply our deep industry experience with buy-side participants, sell-side banks, custody banks, industry utilities, and collateral management solution providers to helpyou achieve your program objectives.


Capability Description Services

Collateralmanagement bestpractices

• Collaborate with professionals whohave proven industry experience incollateral management strategy,operations, and technology.

• Leading practice workflows.

• Collateral optimization services.

• Tech/operations automation/STP.

Multi-generationplan

• Develop a multi-generation strategyto enable rapid transformation andaccelerated value.

• Collateral strategy development.

• Target operating model (TOM)development.

Technologysolutions

• Utilize our industry provenmethodology to unlock rapid andenduring value from leadingtechnology solutions.

• Technology selection andimplementation.

• Agreement/documentationmanagement solutions.

Risk/regulatoryframework

• Address collateral managementrisks across all products with PwC’stailored and systematic approach forrisk management.

• Regulatory compliance solutions.

• Risk mitigation and management.

• Settlement risk efficiency/reduction.

Disciplined largeprogramexecution

• Establish a program managementoffice using an adaptable projectmanagement methodology andtoolset.

• Program management.

• Vendor and service providertracking.

FS Viewpoint | Appendix—Select qualifications28

Project and client Issues Approach Benefits

Collateral operationsrisk and compliancereview—Globalinvestment bank

The bank needed help reviewinggovernance, risk, and compliance aspects ofits collateral management operations acrossOTC derivatives, prime brokerage, and repofunctions. This required the documentationof target-state requirements, as well as thedevelopment of tactical and strategicsolutions to address functionality gaps.

PwC facilitated several working sessions to:

• Assess the client’s global treasury creditmanagement operations, including the governance,control environment, measures, limits, analyticsand reporting, and the collateral managementinfrastructure for OTC derivatives, repo, and primebrokerage.

• Assess process and control gaps for legaldocument negotiation, client on-boarding, andmargin call processes.

• Assess procedures for the processing of interest,dividends, and corporate actions, as well as theindependent verification process.

As a result of this project, the clientidentified numerous gaps in governance,technology, resourcing, and operationalprocesses. PwC’s strategic and tacticalrecommendations enabled the client toimplement a prioritized plan that specificallyaddressed these issues.

Collateral assetprotection for clearedOTC derivativestrades—Global custodybank

The custody bank needed help in facilitatingthe flow of collateral between itself andderivatives users, futures commissionmerchants (FCMs), and centralcounterparties (CCPs). It was looking for atarget operating model, account structures,operational workflows, and systeminterfaces, as well as integration of multipletechnology platforms, to ease collateral flowand protect all parties in the event of default.It also wanted the target model to complywith multiple regulatory requirements.

PwC facilitated several workshops to develop thetarget operating model and aid assimilation of the newservice within the custody bank. The PwC team helpedmanagement:

• Develop process flows, document datarequirements, and analyze interfaces to designreal-time data flows.

• Conduct business requirements sessions withexternal stakeholders, including FCMs and CCPs.

• Map regulatory requirements to the proposedsegregation offerings (LSOC/ISA).

The bank was able to deploy an industry-leading solution that met an urgent need forits clients. This solution:

• Offered participants superior collateralasset protection that facilitated the flowof assets to secured parties.

• Integrated this service with other relatedofferings, leveraging the bank’s existingclient base.

• Achieved operational and technicalefficiencies that helped contain costs.

Response to regulatorymandate —Large tri-party repo agent bank

The bank needed assistance in developinga response to the Federal Reserve’s Tri-Party Repo Task Force’s mandate toexplore the possibility of converting thisfunction to a market utility. It required an in-depth analysis of many regulatoryrecommendations, as well as coordination ofpriorities across stakeholders from thetechnology, operations, client management,legal, and compliance functions.

PwC helped develop and manage a cross-functionalproject management office that analyzed all TaskForce recommendations. This included:

• Providing capital markets and technical experienceto help devise approaches for implementingrecommendations.

• Assisting stakeholders from technology,operations, client management, legal, andcompliance in developing and executing a detailed,risk-prioritized action plan.

• Developing an automated dashboard for weeklyreporting to internal stakeholders, bank clients, andthe Fed.

As a result of the project, the client had adetailed understanding of the requirementsto convert the tri-party repo function into amarket utility. This understandingincorporated a thorough analysis of multipleinternal and external views, including thoseof the bank’s client and the Fed.

Appendix—Select qualifications


© 2015 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwCrefers to the US member firm, and may sometimes refer to the PwC network. Each member firm is aseparate legal entity. Please see www.pwc.com/structure for further details. This content is for generalinformation purposes only, and should not be used as a substitute for consultation with professionaladvisors.

“Not a game of chance: The case for stronger collateral management,” PwC FS Viewpoint, May 2015.www.pwc.com/fsi.

www.pwc.com/fsi

To have a deeper conversation, please contact:

John Garvey [email protected]+1 646 471 2422

Thomas Ciulla [email protected]+1 646 471 0519

Bala Annadorai [email protected]+ 1 646 471 1983

Jeffrey Ford [email protected]+44 (0) 207 804 9177

Gaurav Joshi [email protected]+ 1 646 471 5798

Manan Shah [email protected]+ 1 646 471 5176

Mayur Java [email protected]+ 1 646 471 7912

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A publication of PwC’s Financial Services Institute

Marie Carr

Principal

Cathryn Marsh

Director

Emily Dunn

Senior Manager

Kristen Grigorescu

Senior Manager

We would like to acknowledge the contributions of Andrew Schwartz to thispublication.

Documents

Not a game of chance - PwC · operational, and settlement risks. Comply with regulations aiming to make markets more transparent, resilient, and less reliant on central bank funding