An evolving collateral ecosystem

Managing collateral has become highly strategic. It’s a complex ecosystem that encompasses providers and takers, agents and vendors, venues and clearing houses. It facilitates the interplay of regional and global demands.

In our conversations with clients and industry partners to assess the global state of collateral, we’ve identified ten macro-level themes. Learn how these are influencing counterparties and other ecosystem participants as they make decisions, assess opportunities and deploy their resources.

Across the industry, we are seeing a subtle shift: a focus on revenue growth and profitability as institutions have become more efficient at managing and adapting to regulatory change. In tandem, demand for scalable and cost-effective solutions is increasing, even as firms focus on optimizing their management of collateral.

Taking a global perspective, we see balances growing but with an important caveat: borrowers tell us that this growth is driven more by that focus on optimization instead of a rising balance sheet.

As institutions met the regulatory requirements of the last decade, financing and lending activities kept pace. Not surprisingly, the individual developments needed to comply with multiple waves of regulatory change have not necessarily resulted in an optimal operating model. Post implementation, firms are looking to fine- tune and drive for efficiency, seeking to maximize the effective use of collateral and manage their internal capital utilization across specific desks, regionally and on a firm-wide basis before going out to the market.

While standardization is essential in order to achieve desired efficiency, it should not be at the expense of innovation. Many believe that the creation of new market constructs for the future should be agreed rather than defined or imposed by any one single industry participant. It is, however, important to agree on best practices so that counterparties are able to effectively interact with one another. That could come either through industry conversations on best practices, based on the experiences of individual firms, or by normalization and acceptance of models put forth by external providers. The key will be to balance the flexibility needed by individual firms with the benefits that stem from common processes.

Institutions are focused on where they can effect change based on the things they can control, such as identifying and creating a target operating model, directing investment, managing price and optimizing their collateral. Tri-party provides one engine to facilitate the deployment of those optimization strategies, with capabilities that support margin management, stock loan and repo.

While the operational management of collateral remains in the middle and back-office, its importance has made it a front-office concern. Trading desks increasingly focus on the cost or availability of collateral, or the collateral requirements of a transaction, as part of their decision-making process. Furthermore, collateral itself has value: depending on the type, source, term or counterparty, excess collateral could be traded like any other scarce financial resource.

The ability to mobilize collateral across regions is also essential: this requires knowing what assets you have, where they are and how you can move idle or unused collateral to the right place. In certain Asian markets, tri-party structures are helping to unlock assets trapped in illiquid markets for use in on-shore and off-shore financing.

However, legal entities create additional layers of complexity, particularly for large universal banks. This is due to the need to manage complex internal connections and adhere to different jurisdictional or cross border requirements.

The quality of the counterparty remains paramount but your counterparty, and how you face it, is evolving:

  • If you use a CCP, the CCP becomes your counterparty and your credit decision is effectively outsourced under the CCP’s mutualized risk model.
  • Alternatively, peer-to-peer networks facilitate bilateral arrangements, requiring a direct evaluation of counterparty quality.

Lending counterparties are also evaluated for credit quality and to determine whether they will be able to provide meaningful supply and liquidity during times of high demand.

Finally, collateral quality remains a keen focus. High quality liquid assets are in high demand, particularly for broker dealers managing against complex balance sheet, capital and liquidity constraints.

Interoperability, industry solutions such as CCPs, vendor solutions and the ability to assemble components into partially bespoke solutions are giving institutions more choices in managing their financing and collateral portfolios.

The traditional supply chain is likely to expand to include non-traditional solutions. However, new options will require adaptation and adoption to be effective. For example, peer-to-peer platforms will require critical mass and scale to make them attractive in terms of access and liquidity, and counterparties will need to conduct their own due diligence on the institutions they face in these bilateral platforms.

Agent lending models are also evolving to attract new borrowers and lenders and expand the available pool of assets.

Tri-party structures continue to expand beyond traditional stock loan or repo. Pledge structures, which were originally discussed as a solution to manage haircuts or margin, could be used for the entire loan exposure amount following the successful use of pledge models in tri-party for segregated initial margin. These structures leverage the existing market infrastructure, and may be quicker to market than other emerging options, such as CCP structures for securities lending.

The pace of change also depends upon the appetite of buy-side institutions to adopt new structures. This continues to be the topic of significant conversations amongst collateral borrowers, lenders and agents, given the introduction of uncleared margin rules.

Intense investment spending to comply with regulatory change over the last decade is now giving way to more flexibility in allocating spend. Investment funding is focused on increasing efficiency, reducing costs, improving the customer experience and increasing connectivity. Online tools facilitate eligibility schedule management and collateral allocation deployment, while big data initiatives and advanced analytics aid decision making. Being able to combine data across an institution, for one common source of information, is critical, particularly across multiple desks or regions.

Technology that supports interconnectedness and interoperability amongst members of the collateral ecosystem will ultimately create additional efficiencies. As individual firms continue to innovate internally, we expect that fintech will help to connect the dots between different institutions in order to improve the broader model.

As with any ecosystem, participants must remain adaptable in order to thrive.

For agents, that means going beyond the critical service of mitigating operational and counterparty risk. As the management of collateral becomes more sophisticated, agents must now be able to:

  • Provide collateral eligibility and allocation services that are nimble and can support complex, bespoke and fluid counterparty requirements.
  • Support a wide variety of asset classes, underlying principal trade structures and markets to facilitate the global deployment of collateral across multiple client legal entity structures.
  • Work closely with clients, providing tools to help them achieve the optimal use of their collateral in accordance with their own internal demands and binding constraints (capital, liquidity, etc.).
  • Deliver on-demand reporting and transparency to facilitate intraday collateral and funding requirements.

We expect the pace of change to accelerate as innovative technology and new platforms create evolutionary opportunities, and traditional barriers continue to soften. We look forward to working closely with our clients and industry partners to identify and adapt to emerging opportunities.

To learn more about our global collateral management offering, including our advanced eligibility management and optimization capabilities, please contact your J.P. Morgan relationship manager.

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Copyright © 2019 JPMorgan Chase & Co. All rights reserved.