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Cristina McEachern
Cristina McEachern
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As Darkness Descends on Enron, Light is Shed on Collateral Management

The Enron tumble is the latest in a string of high-profile, credit-risk catastrophes that have plagued the financial-services industry. Wall Street is taking notice and discovering that collateral management is an important tool to mitigate credit risk and protect against counter-party default.

David Maloy, managing director, global collateral and margin at UBS and co-chair of the ISDA collateral committee, explains that as firms are dealing with increasing numbers of collateral agreements, moving beyond spreadsheets becomes a necessity. ""Once firms get beyond a hundred agreements or so, desktop solutions don't work,"" he points out. ""You need something that is far more robust, something stronger that can keep up with the deals.""

Timing and the ability to value risk positions also lead to the need for technology, says Maloy. The key to technology, he adds, is ""the ability to take a view of the theoretical value of risk positions and somehow tie that into the collateral that's moving in and out of the account. This will help to make a decisions and to put the processes in place to take the collateral and/or pay collateral depending on what the agreement is.""

In order to achieve the greatest benefit from having such technology in place, Maloy advises that the collateral systems be closely tied to trading and execution systems, as well as treasury-management systems and credit-risk systems. Maloy adds that his global team relies on an almost exclusively in-house built system, and generally has between five and 30 people operating offices in all major capital markets, including Switzerland, North America, Asia/Pacific and London.

Barclays Capital also depends on an in-house-global platform to manage its collateral, says James Crabb, head of collateral management for Europe at Barclays Capital. He adds that integrating collateral systems with other credit-risk systems should be a pre-requisite for any collateral-management program.

""There is no point in setting up a collateral program if you are not prepared to report or reflect the benefits of that program throughout your risk systems, your treasury systems and regulatory-capital systems,"" says Crabb. Barclays Capital's global-collateral-management team is composed of about nine people in London, five in New York and two in Tokyo.

He adds that in the past, participants in the collateral market tended to check and re-calculate values on a monthly basis. But these days the calculations are generally performed on a daily basis, reinforcing the need for technology to keep up when dealing with large amounts of collateral and larger numbers of agreements in place to govern these relationships.

""With more users and more holders of the collateral, liquidity should increase,"" says Crabb.

In terms of credit-risk lessons, Crabb says that the major events seem to happen every couple of years. And the most important thing to come out of these reminders? ""They put everyone's internal procedures, controls and systems to the test at the time,"" says Crabb. ""But in effect they should be fine tuning for these occurrences anyway.""

On the other side of the spectrum, Bank One has been using Algorithmics' Algo Collateral (Sentry) system since 1999. Overall, Johnson says that collateral management is a ""significant function of our credit-risk-management area."" The Algorithmics system covers all of the bank's derivatives products, including interest rates, commodity, credit and equity derivatives as well as some foreign-exchange products.

Bank One uses the Algo Collateral system to handle the 200 collateral agreements it has in place and its 3,500 to 5,000 transactions. ""We take all of our transaction-processing systems and feed them into a central repository and that repository feeds all of the underlying-transaction information to the collateral system,"" explains Johnson.

""Then the system will take the mark-to-market values and bucket them by counter party. It will also look at those values in relation to what our (credit) thresholds are under the agreements and act on whether or not we need to make a call or should expect a call from a counter party for putting up additional margin.""

The use of collateral-management technology not only enables Bank One to more effectively monitor its collateral agreements and exposures with counter parties, Johnson says it has also made the firm ""volume insensitive."" In other words, ""We can monitor an agreement with a large-financial institution that we may have over 2,000 outstanding transactions with just as easily as with a counter party that we have five outstanding transactions with,"" explains Johnson.

Technology Trends
As the collateralization trend continues to pick up speed in the financial marketplace, the technology will likely see some new functionality to keep pace with the changes.

Looking forward, UBS's Maloy says some of the larger global players could be moving to bring all of their collateralized products together under a common department using the same or closely-tied systems.

ISDA's Marshall adds that although it is a huge logistical undertaking, there is a trend toward enterprise-wide-collateral management in the derivatives arena. ""Enhancements in the technology to support collateralization will definitely support this trend,"" she says. ""Without these developments, the needs created by daily margin calls across a firm's different product areas would be difficult to manage.""

The ISDA 2001 Margin Survey also points this out and states, ""Integrated, enterprise-wide collateral management is a strong future trend, which will be realized over the next several years as further technology investments are made.""

Jeff Seimer, product manager for Algo Collateral (Sentry), agrees that bringing collateralization across products and desks would be a big step forward. ""Clearly if I am dealing with three trading desks that are all dealing with the same counter party and all have separate margin provisions, then it's advantageous to be able to provide one face to my counter party,"" he says.

In this case, the collateral positions across the various trading portfolios could then possibly be consolidated. ""Being able to re-allocate collateral between the various silos of trading would make life easier for my counter party and at the same time give a better picture of what is going on with them,"" adds Seimer.

Improving communications and processes would be important for any work toward collateralizing across products and desks. ""Firms need to be getting information to and from the trading area and to and from the other risk areas,"" says Paul Murphy, president of SunGard Collateral.

Meridien's Williams agrees that closer integration and improved data sharing are important moving forward with collateral-management technology. She sees the integration of collateral-management functionality with enterprise-credit-risk analysis as the only way to achieve a complete view of credit risk. ""It's just like any other customer information, it's nice to be able to access it on a centralized basis rather than have to hunt throughout the enterprise,"" says Williams.

But before this vision becomes a reality, there are some major hurdles to bringing the various collateralized products and agreements closer together. One aspect is the separation within institutions between the different areas. When the collateral departments aren't communicating, it is difficult to share processes and technology. There are also legal issues concerning the use of collateral and collateral agreements between various entities within an overall firm that, for example, has a different name or two counter parties that are in different countries.

Algorithmics' Seimer compares the concept of actually achieving enterprise-wide-collateral management and cross-product collateralization to the cart before the horse argument, except in this instance there are three aspects -- the processes, the technology and the legal issues. While in theory, participants are open to the idea, they would want the technology to be ready and the legal agreements in place in order to really move forward.

So no matter which aspect starts the ball rolling, once it gets rolling, Seimer sees consolidated-collateral management as the next big step.

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Spending on collateral-management technology is expected to grow
significantly in the next few years, according to Meridien. While spending on dedicated-collateral systems was around $54.5 million in the year 2000, Meridien estimates that spending could reach $134 million by 2005, with financial institutions in North America and Europe expected to be the biggest spenders.

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Essential technology components
* According to Meridien Research, collateral-management solutions should have five main components.

* The system should have a data capture and transaction for static and reference data on counter parties. This data should be integrated from the various other data sources and be able to feed back into a credit-risk system.

* A workflow module is important for the different movements of collateral. For example, whether the collateral is pending or has been received. This component should also monitor the value of the collateral.

* Collateral systems should incorporate an analytic engine, or feed into an analytic engine, in another credit-risk system for the calculation of value-at-risk.

* Collateral-management systems should include reporting functionality with calculations, such as interest earned, coupon payments sent and received and profit and loss statements.

* A documentation database is also a key component for any collateral solution. This database must hold counter-party agreements and legal information. In general, larger financial firms tend to rely on proprietary systems built in-house, while medium to smaller firms are increasingly turning to vendor solutions.

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