Collateral Transformation, Agency Execution to Reinforce Swap Dealers' 'Stickiness'

To start with, a projected shortfall in eligible collateral—potentially in the trillions of dollars—means transformation and optimization tools will be crucial. As BNY Mellon's Nadine Chakar puts it, the various "building blocks" required to make that happen require heavy technology investment.

"First of all, you have to connect the dots," BNY's head of global financial institutions says. "This means knowing where your collateral sits through aggregation platforms that are legal-entity aware. Then comes the optimization, recognizing different things like segregation regimes and counterparty exposure. There are a lot of different ways to slice and dice this data, but the overall idea is that post-trade activities are moving to pre-trade, especially with new Basel III funding requirements. A year ago, a buy-side trader didn'ty worry about any of this, but with so many new types of participants now interjecting themselves into the trade lifecycle, and everything from pricing to collateral valuation required to be available in near-real time, it's a huge overhaul."

Eric Wilson—a director for Wells Fargo Securities who helped the bank launch its futures commission merchant (FCM) arm—likewise says that there is a need to provide information faster, but uncertainty around the rules has demanded building tactically.

"Things like 'what-if' scenarios and intra-day variation margin, meant that we've tried various attempts at [technology] combination and changed direction three or four times," Wilson says. "In the bilateral world, all this was T+1, but now that isn't sufficient. For us, one of the big strategy changes was cross-margining of futures, where we had those platforms operate separately before, but it was fairly obvious early on that Chairman Gensler wanted this to look like a futures model. That was helpful, and we built to that, with the idea that clients would tell us what functionality was important. Interestingly, collateral optimization hasn't been used a lot up front, but we fully expect that to be important across both central counterparties (CCPs) and, eventually, even across futures commission merchants (FCMs)."

Timing
Indeed, BlackRock's co-director for electronic trading, Supurna VedBrat, points out that for large buy-side firms like the $4 trillion money manager—managing around 12 executing counterparties and seven clearing members for its swaps operations—moving IT changes in sync with all partners is essential.

There are a lot of different ways to slice and dice this data, but the overall idea is that post-trade activities are moving to pre-trade, especially with new Basel III funding requirements. ─ Nadine Chakar, BNY Mellon.

"You're only as good as the weakest link in the chain," she explains, "And there is a lot of risk in the new system that resides with the end-user—as interoperability among entities increases, a lot of grey area is introduced in what happens when something goes wrong. For the buy side, we need margin efficiency, setting the right margin at CCPs, offset between swaps and futures, or changes with eligible collateral. More standardization around corporate bonds would mean those start to look and feel like something that could be eligible. Another impact is on the repo market ─ that is where a lot of transformation happens, and changes to capital requirements could well impact the supply of what is eligible, as well."

Dealers, therefore, are trying to keep balance sheets better managed—in part, Wells Fargo's Wilson points out, by keeping notional swaps outstanding down and including a greater range of contracts in risk-constrained portfolio-compression cycles like TriOptima's.

"I know we've been more aggressive on that, but still a lot of other concerns remain about credit we have to deal with," he says. "For example, the two-minute rule originally posed enough stress; now, we're down to 60 seconds for [pre-trade] credit checks, and to give clients that certainty, as well as people within our own organization—who are fairly conservative around credit risk—we needed to go back and do a lot around the technology backing that."

Timing around credit checks is similarly an issue for the buy side, BlackRock's VedBrat says. Asset managers once were able to do a trade, then allocate it later, but the mechanics mean that order is no longer acceptable. "You could allocate on a pre-clearing basis in the old world. In the new one, you clear and then allocate after, so this means for trade execution we're very dependent on the CCPs, the credit hub FCMs use to provide a defined credit limit to check against, and SEF rulebooks, which at this point we simply can't say we're entirely comfortable with on the legal risk side," she says.

Cautiously Optimistic
Still, after three years of build-out—including centralizing BlackRock's enterprise collateral management into a single operation—VedBrat was "cautiously optimistic" as the firm back-tested its new execution function last week. What she's interested in now is how dealers are able to offer swaps-related services in a newly-fragmented environment that will quickly come to look more like equities. BNY's Chakar suggests securities-lending is one area ripe for even greater use in transformation. Geography, VedBrat says, is another concern.

"The rules are written all-to-all, but this will become more of an agency model," she says, "If we source clearing through the banks, only to discover some of them aren't recognized by European Market Infrastructure Regulation (EMIR), that means massive unwinds for us, but the timing with Dodd-Frank just hasn't allowed for much harmonization. Some wonder whether we're recreating the old bilateral risk with collateral transformation ─ just one layer outside ─ and whether that is true or not, we need to have transparency as to where collateral resides. I'd say we have to watch that closely."

In fact, despite all-to-all and impartial access rules governing central limit order books (CLOBs), even a giant like BlackRock will only connect to about five SEFs directly out of the 17 currently operating.

"As a sell-side desk, those rules mean your stickiness to the client begins to move away, but an executing-broker model helps," VedBrat continues. "Doing some transaction-cost analysis, looking at the cost of maintaining that infrastructure, a buy-side firm who isn't a large or frequent user of swaps will probably find that [agency] route very beneficial."

For dealers, then, who wins out is a simple matter of willingness to really go the distance, both on tech spend and risk on-boarding.

As Chakar puts it: "Scale and capital."