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Outsourcing collateral management: an evolution

Citi explores the key challenges and strategies available in the market for optimal collateral management with respect to costs arising from technology and human capital needs.
Outsourcing collateral management: an evolution

The sub-prime crisis of 2008 both influenced and played an instrumental role in the growth of outsourcing banking services.

As the crisis gained momentum, spilling into global markets in the third quarter of 2008, the defaults of banking giants sent shockwaves through every segment of the market.

Regulators, risk officers and senior management at banks and buy-side firms shifted their attention from traditional market risk management towards gaining a better understanding of the nature of credit risk.

As markets globally began to absorb the magnitude of the crisis, regulators were the first to react, putting in place a series of proposals to enforce credit risk management and transparency, especially in the over-the-counter (OTC) derivatives markets – a roughly $700 trillion market where much of the activity is bilateral in nature and therefore opaque to the public.

Amongst the new regulatory measures proposed by both Dodd-Frank Act in the US and the European Market Infrastructures Regulation (EMIR) in Europe, the more prominent ones that took effect immediately were mandatory trade reconciliation, trade netting and trade affirmation.

Although not a direct regulatory ruling, the various initiatives taken up by market participants to enhance controls around its credit risk exposures also included the implementation credit support annex (CSA), or collateralisation of bilateral trading relationships. 

As these measures were introduced, both buy- and sell-side market participants soon woke up to the challenges of implementing them on a practical level.

The move to mitigate credit risk through new regulatory measures actually led to an increase in operational risk, as market participants struggled with two main issues – how to deal with increasing costs associated with upgrading systems and processes and also where to find the technical know-how of implementing and integrating the new regulations into their internal infrastructure and processes.

In short, a need for expertise, new technology and finding the optimal investment strategy for dealing with new regulations were the key elements that defined the OTC landscape post the 2008-09 financial crises.

The remedy came in the immediate years following the financial crisis, as the market saw a gradual introduction of securities and fund services focused on risk mitigation products and operational services offered by a few large global banks and custodians. Amongst such services, collateral management is arguably one of the fastest growing. 

Whether a firm is looking at outsourcing their collateral management, building in-house solutions, or considering a vendor platform, understanding and having an optimal strategy for collateral management is arguably the most topical subject in today’s global OTC markets, with increasing interest from all segments in Asia-Pacific Rim region.

Please click here to access a detailed article on this topic by Citi. Based on discussions and feedback from approximately 100 market participants around the Asia-Pacific Rim, it seeks to explore the key challenges and issues in terms of collateral management in the region.

It also explores the various strategies available in the market for optimal collateral management with respect to different costs that arise from technology and increasing human capital needs.

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