Founder of the US state of Pennsylvania William Penn once said that “time is what we want most, but what we use worst.” For financial institutions, the recent decision by regulators to delay the final two phases of the uncleared margin rules (UMR) certainly provides additional time, but it needs to be used effectively to seek out operational efficiencies across the business.
No market participant needs to use the additional head space afforded to them more than smaller investment firms set to be pulled into phases five and six. As a case in point, take an asset manager who may well be trying to work out the most effective way to segregate collateral. Prior to the delay, an asset manager like this might go for a tri-party solution where the collateral is allocated for them.
Not because they necessarily need it, but it could well be that an asset manager with limited resources is unlikely to have the time to establish complex processes in-house. It may be far easier, and indeed more logical, to outsource the work to someone else. However, now with another year to play with for phase five firms, and two years for those pulled into phase six, can asset managers find a cheaper option to achieve segregation? Can they streamline their collateral processes to the extent that they could possibly use a third-party custodian? Or, alternatively, should the asset manager perhaps stick with a tri-party approach by outsourcing everything?
For those firms currently mulling over whether to go down the tri-party or third-party custodian route, the final decision will ultimately come down to whatever the most cost-efficient option is. And this will differ drastically depending on the nature of the assets the investment firm in question has on its books. According to the latest ISDA survey, it would appear that the majority of the collateral currently in use is of a fairly vanilla nature – like sovereign bonds.
The thing is that a lot of the phase five and six firms only have a certain number of sovereign bonds on their books. Therefore, it might not make much sense for them to buy a fully automated tri-party service as it could potentially be cheaper to build support to streamline the process internally rather than outsourcing it to a tri-party. After all, if a firm only has a handful of sovereign bonds lying about, they are limited in terms of what bonds they can choose to post as collateral. Where a tri-party could become an attractive option is when an investment manager has a complex portfolio of collateral on its books. A fund manager might typically have a portfolio comprising of multiple equities, corporate and sovereign bonds that, particularly with the recent levels of market volatility, need highly sophisticated internal support to achieve efficiencies.
As firms continue to debate the best approach to take following the BCBS and ISCOs delay letter, those that take the most pragmatic approach to segregating collateral will be in the best position. For those only using cash collateral today, the additional operational requirements brought about to segregate non-cash collateral may seem more attainable given the extension. One thing is for certain, financial institutions need to use the time to clearly understand each model and assess not just their operational capacity, but their systems capability too.
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