Friday, September 6, 2013

A Whole New World of Collateral Optimization

Some optimisation techniques are still taking shape due to a lack of clarity around new regulations. However, some elements must naturally precede others before it is possible to reach the next level.

Post crisis regulatory changes have had dramatic effects on the landscape of collateral management, and amplified greatly its importance from a risk management, funding cost, and operational standpoint. As a result, financial institutions across the globe are overhauling their collateral management processes to deal more effectively with the new market for collateral. Traditionally, the concept of "collateral optimization" was limited to examining what is cheapest to deliver, assigning costs to collateral assets, mapping eligibility criteria, and centralizing collateral across business lines. But as a new white paper from 4sight Financial Software points out, in the new regulatory climate and collateral marketplace, effective optimization now requires a much more dynamic and custom-made approach. According to the report entitled, 'Collateral Optimisation: Beyond Cheapest to Deliver and the Big Red Button, authored by Martin Seagroatt, head of global marketing for 4sight Financial Software, a ‘one size fits all approach’ to collateral optimization is doomed in this environment, and effective optimization must now be tailored to the unique strategy and business model of each firm.  The 4sight paperpaper gives an overview of the latest techniques used to optimize collateral and discusses some of the limitations of collateral optimization. It also provides a list of questions financial firms should ask when implementing a collateral optimization project. 

According to the white paper, in the minds of many, collateral optimization is merely a "big red button" that when pressed, "can perfectly allocate all collateral assets in real time on an intraday basis." Tempting as this concept is, 4sight believes such a system is too static, undynamic, and could be more disruptive than helpful.  This is because, in the current collateral environment, optimization is a moving target, not a static one.

There are a great many factors and costs influencing efficient allocation. It is difficult from an operational point of view. It is also a constantly moving target due to increasingly frequent changes in asset ratings and counterparty eligibility criteria. It requires significant investment in technology, data mapping and development of complex algorithms that are unique to each firm. There are also constraints around how fast collateral allocation data can be processed to support pre-trade decision making. As with most activities, there is an 80/20 rule in play. The added effort required to achieve the hardest to obtain cost savings is often not worth the diminishing returns. Optimization is based on the best practical allocation of collateral, rather than the best possible allocation.
This is precisely why 4sight opposes a one-size-fits all approach.  What is optimization for one firm, may not be for another.  Plus, optimization efforts can be expensive, technically demanding, time consuming, and sometimes frustrating for counterparties and others.  4sight counsels a deep soul searching cost benefit analysis before launching a program of collateral optimization.

It is important to make a pragmatic choice based on whether the extra few basis points saved in collateral costs from the more advanced techniques are worth the financial investment as well as time and IT resources. For some firms, this complex multi-factor optimization is worthwhile, for others the basic techniques offer the optimum cost-benefit trade-off.