Creating an effective collateral management program through improved technology and business practices is important for mutual fund providers. The collateral management industry is in the midst of its most significant transformation ever as regulators engineer a derivatives market structure designed to mitigate systemic risk. The financial press is using worrying phrases like "collateral liquidity crunch" and "collateral scarcity," and introducing new terms like "collateral transformation", which are leaving mutual fund providers and other market participants anxious and confused. Business practices are changing as boards of directors, institutional investors and other stakeholders demand improved transparency, standardization and risk management.

Why does this matter for mutual fund providers now? Collateral management is evolving to address new regulation, such as the Dodd Frank Act. In early April, BBH expanded its collateral capabilities though a partnership with the Chicago Mercantile Exchange for the clearinghouse's IEF4 program, which allows participants to deposit corporate bonds as collateral for listed derivatives and cleared OTC swap contracts in a tri-party custody account with BBH. The support for corporate bonds as collateral is part of a larger effort to meet the increase in collateral required by the derivatives industry in light of new regulation, specifically the requirement to centrally clear swaps.

As a result of this industry overhaul, mutual fund managers must consider collateral as a valuable resource that should be managed with discipline and efficiency in order to reduce its impact on portfolio performance. In the derivatives space, collateral management helps protect an entity from counterparty risk by calculating counterparty exposures, and requesting or pledging collateral to cover open, unfunded economic exposures. An inherent part of bilateral swap transactions is the associated counterparty risk, and the means to collateralize that exposure will always be a paramount risk management function.

Given that counterparty risk is tied to swap transactions, it is important that investment managers understand that this risk assumption can be mitigated - though not eliminated - through robust operations, sophisticated technology and a strong commitment to collateral management. The way counterparty credit risk is managed is in flux, and consequently collateral management practices will continue to change to accommodate the evolving derivatives market structure.

COMPETITION FOR A SCARCE RESOURCE

In the new regulatory environment the total cost of trading will increase. Some mutual fund providers may change their trading strategies to avoid the increasing collateral obligations. Others may seek ways to minimize those costs so that derivatives can remain a part of their portfolio strategy, requiring a more robust technology platform. If derivatives remain, mutual fund providers must address three key front office concerns: higher volume of collateral movements, increased value of collateral required and more restricted eligible collateral. More assets need to be earmarked to cover the new collateral requirements, limiting the front office's ability to use these assets to generate portfolio returns. High quality collateral could become scarce and there will be competing priorities for the use of collateral within a firm, hence the need for a discipline that maximizes the efficiency of this valuable resource to reduce its impact on portfolio performance.

CREATING AN EFFECTIVE COLLATERAL MANAGEMENT PROGRAM

Increasingly complex collateral management challenges are accruing to widen the gap between today's definition of a viable collateral management solution, and that of the future. Developing comprehensive collateral management best practices is more important than ever and mutual fund providers would be prudent to consider a program that employs the following:

*Robust eligible collateral inventory tracking

*Collateral optimization technology to support the most efficient usage

*Opportunities for netting exposures across counterparties and asset classes

*Technology to analyze collateral implications pre-trade so that the optimal execution path is followed

*Options for collateral transformation services

*Capacity to increase the frequency of collateral substitutions without straining operational resources

A combination of the above attributes should alleviate collateral pressures faced by the front office. These unfamiliar requirements are worrisome for many; however, there is choice in implementing a collateral management solution, and one that has the flexibility to thrive in the new environment is a strategic imperative. While the industry changes are dramatic and regulatory priorities can shift, making the right technology investments and prioritizing the above best practices can alleviate those concerns and limit the negative consequences.

Stephen Bruel is head of derivatives product management at Brown Brothers Harriman

Subscribe Now

Access to premium content including in-depth coverage of mutual funds, hedge funds, 401(K)s, 529 plans, and more.

3-Week Free Trial

Insight and analysis into the management, marketing, operations and technology of the asset management industry.