Collateral Management: Expanding Role, Increasing Complexity

Collateral management has rapidly taken center stage for financial institutions seeking to effectively manage risk. The financial turmoil of 2008 highlighted the importance of collateral management as an essential tool for managing counterparty risk concerns associated with market activity.

Market Turmoil Drives Growth
The use of collateral has grown exponentially (often into new sectors) as institutions fled unsecured activity for more secure havens. According to the 2009 ISDA Margin Survey, collateral in circulation against OTC derivatives grew year-on-year by 86%—to an astonishing U.S. $4.1 trillion.

At the same time, the various disciplines comprising collateral management now endure far closer scrutiny. Liquidity and price volatility of assets are keenly watched, as old assumptions were market-tested in 2008—often with surprising results. Long-held preferences for fixed income securities were challenged when liquidity left the market, while money market funds, the traditional home for cash collateral, proved unreliable when many ‘broke the buck’. Frequent, severe market fluctuations limited the effectiveness of haircuts, often predicated on historical volatility models that were suddenly invalid.

Implementation Brings Challenges
Whether embracing or extending the use of collateral, institutions are finding that creating an integrated strategy is one thing, but implementing it well to achieve stated goals is quite another.

In its purest form, collateral is simply an exchange of risk. Counterparty exposure (or the possibility of default) stems from the legal, operational, and settlement risks associated with collateral management. A well-managed collateral program provides a mechanism for controlling the newly exchanged risk, in contrast to the counterparty default risk which cannot be controlled.

For a certain period of time, those new risks can be supported internally. At some point, however, the institution faces a critical choice: whether to invest in the tools and technology necessary to manage a collateral program that has grown beyond spreadsheets and manual processes/tracking, or whether to engage a partner who can not only support current needs but also provide the infrastructure, expertise and innovation to handle future growth and expansion.

Several factors play into this decision: the required technological and staffing resources, the ability to sustain growth, and the cost-benefit analysis of building, buying or outsourcing. Partnering with a collateral agent is often the most timely and cost-efficient solution for an institution that expects its use of collateral to increase.

If current trends continue, the extension of credit that collateral provides will spur additional business, with collateral increasingly used to defray the credit and counterparty risks associated with transactions. Collateral agents such as J.P. Morgan provide the technology, infrastructure and expertise that allow financial institutions to focus on their core activities, confident that their agent is tightly controlling the operational environment to efficiently manage process, cost and risk.

For further information regarding J.P. Morgan’s Collateral Management services in Australia, please contact Blair Harrison +612-9250-4925 or e-mail blair.harrison@jpmorgan.com