New rules, complex investments transform what was back-office function
Asset owners are taking a broader view of collateral management, with more attention being paid by the front office to what historically was a back-office function.
Begun in response to the 2008-2009 financial crisis, the move to combine oversight of all collateral management — rather than segmented through securities lending and other services — has accelerated as Basel III recommendations and the Dodd-Frank Wall Street Consumer Protection Act have spelled out tougher trading and margin requirements for collateral. Those changes affect not only asset owners' securities lending programs but also their cash holdings, use of derivatives and overlays, and liquidity needed for private equity calls.
The rules — and the complexity of the investments to which they're applied — have meant what originally was simply matching credit with collateral has become far more intricate.
“The backroom work of securities lending, what used to be back office, is now of interest at the highest level,” said Virgilio “Bo” Abesamis III, executive vice president at Callan Associates Inc., San Francisco. “Now it's an investing thing.”
“The (pension fund) industry is going” toward executives taking a closer look at their collateral management, Gary McGuire, chief investment officer at Dow Chemical Co., Midland, Mich., which has $13.5 billion in U.S. defined benefit assets. “Because we trade a lot of derivatives, we monitor that collateral closely and daily.”
“It's now a matter of portfolio management,” said William Atwood, executive director of the $14.2 billion Illinois State Board of Investment, Chicago. “It's not about lending securities anymore, it's about borrowing collateral.”
If fully implemented, Basel III recommendations, pending European regulations and Dodd-Frank rules would require collateral to be much more liquid to meet two types of margin requirements: initial margin to cover the fluctuation in a contract's value over a fixed period; and variation margin to offset the daily fluctuations in the swaps contract's market value. Also, collateral will need to be posted through central clearinghouses rather than over the counter or through dark pools, and a variety of protections will need to be in place in case of counterparty default.
But with those rules comes the need for more oversight and more collateral. That, in turn, means more involvement and oversight from chief financial officers, chief operating officers, treasurers and pension fund risk managers, said Fergus Pery, director and head of Europe, Middle East and Africa open collateral at Citigroup Inc., London.
The broader view is “a blurring of the lines” between securities lending and collateral management, said Callan's Mr. Abesamis. “A pension fund client who is in both securities lending and in overlay strategies needs to know about its overall exposure to counterparties. The pension fund needs to aggregate its exposure and the type of collateral selected.”
The regulations “are punitive, in a sense,” Mr. Abesamis said. “Now, every counterparty has to make a determination that the collateral is the highest quality possible. That costs more, depending on the transaction.”
Large custodians like Citigroup, Bank of New York Mellon (BK) Corp. (BK) and State Street Corp. (STT) and niche firms like eSecLending LLC have combined collateral management services with securities lending in a trend dubbed by the industry as “collateral optimization.” James Slater, executive vice president and head of securities finance for BNY Mellon Global Collateral Services, New York, said combining the functions helps investors meet collateral requirements across a wider array of investments and asset functions.
“The buy side now has collateral requirements that either didn't exist before or were done off the corner of someone's desk,” Mr. Slater said. “Requirements are much more complex for pension funds, and many of them have finite resources to determine what to do with collateral. They need to meet regulations and also be more efficient. They have to do some planning, so they get help from their custodians.”
The regulations can make collateral management more onerous for asset owners, but it can remain a source of alpha if they use the collateral wisely. “For pension funds, it's all about optimizing collateral, looking at the lending program in the context of the entire fund portfolio and how it can be used to benefit the entire plan,” said Phil Picariello, senior vice president and head of short-term investment management at eSecLending in Boston.
Others said reducing costs that increased because of regulatory requirements is a driving force behind the consolidation of collateral management. “Collateral management has become more costly in terms of operations,” said Citigroup's Mr. Pery. “There are more requirements for collateral now than there ever were before.”
At the Illinois State Board, the added oversight of collateral management still focuses on securities lending, Mr. Atwood said, although the board changed that program to obtain Treasuries rather than cash as collateral. “In 2008, we had an unrealized loss of $90 million from our securities lending program. That reality caused us to rethink how we did this, really pay attention to it.”
In 2008, the ISBI, which had $9 billion in assets managed for four state pension funds, had a peak securities lending collateral balance of $1.5 billion. Today, the board has $186 million in securities out on loan, with $129 million in Treasuries as collateral, Mr. Atwood said. Credit Suisse is the board's securities lending agent.
“We have much lower revenue,” he said — $3.9 million in 2013 vs. $21 million in 2008 — “but we've distilled most of the risk out of securities lending. We decided after 2008 to take the risk out or get out of securities lending.”
Dow Chemical officials have paid much more attention to collateral management since reinstating the pension fund's securities lending program with eSecLending in January 2013, Mr. McGuire said, and Dow already complies with many of the anticipated regulations. “That monitoring already allows us to comply with future regulations; those are getting tighter and tighter,” Mr. McGuire said.
Still, said BNY Mellon's Mr. Slater, “the services themselves aren't brand new. It's really the packaging, the connectiveness, that's changed.”
Mr. Abesamis agreed, saying the three layers of securities finance — identifying the collateral, determining the amount of collateral needed and identifying the counterparty — haven't changed. Ultimately collateral management “is what securities finance already does,” he said. “In reality, it's repo (repurchase agreements). It looks like a duck, acts like a duck ... it's the same here. It looks like securities finance, it acts like securities finance, it is securities finance.” n
This article originally appeared in the February 17, 2014 print issue as, "Collateral management gets spotlight".