Earlier this week, BBH partnered with CME 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. Stephen Bruel, global head of derivatives product management at BBH explains how collateral management is evolving to address these regulations.
How did the partnership with CME come about?
SB: BBH has a long relationship with the CME as one of their settlement banks, so we’re very pleased to expand that relationship to support their IEF4 program. To some extent, new regulation is really seen as a cost driver, but what we also see is that regulation is often times a driver of innovation, and I think this is what we’re starting to see in the collateral management marketplace today. So as we see some of the key industry participants developing new products and services, it seems like a natural extension for BBH to support some of those products and services. Given the longstanding relationship with the CME, and given the effects that the IEF4 program can have on the varied client segments that we serve, we felt that it was just natural that we go and support the program. Part of what we’re seeing is that as collateral requirements increase, due to the regulatory burden, there has been a demand in the marketplace for a broader list of eligible collateral. And so the CME extending into corporate bonds supports that need from the industry. There’s no doubt that collateral is a top concern for chief risk officers and chief financial officers, and given that, we expect a lot more of this type of innovation in the marketplace as well.
Are there any plans to accept other types of collateral other than corporate bonds?
SB: The IEF4 program right now is limited to corporate bonds. The CME as the clearinghouse determines what collateral they classify as eligible. I think the demands in the industry will be such that all market participants need to think about what their current collateral eligibility list is and how that might need to expand over time. We’re all hearing terms like “collateral scarcity” and “collateral liquidity crunch,” and we hear that there’s going to be an increase in the value of collateral required. The concern is really that people might not have enough of the right collateral, so extending to new collateral asset classes like corporate bonds helps alleviate some of that collateral crunch.
What else needs to be done to meet the growing collateral needs?
SB: There’s no single solution that’s going to resolve the need for more collateral. Industry estimates seem to be coalescing around three to four trillion dollars in new obligation in collateral. And so it’s not simply a matter of saying let’s extend the list of eligible collateral; that is absolutely one vital piece of the puzzle, [but] there are other important pieces of the puzzle. There’s a need for the right technology to find the right collateral, to optimize the collateral based on the agreements that you have with your counterparties. There’s the need for operational efficiency to maximize the ability to substitute collateral in more of an on-demand manner. This is a conversation that needs to extend well beyond simply the collateral list and over to optimization and operational efficiency, and also, frankly, trading patterns. I think the key question is how front-office trading decisions will change due to increased collateral cost. And in order for the front office to understand the collateral implications of their trade, they need the right tools and the right technologies that help demonstrate it’s not just the cost of the trade itself that matters here; you now have to include the cost of collateralizing the trade when you start to think about the best way to execute against your portfolio strategy.
What is BBH working on to address these needs? Will there be more partnerships, investments in technology, etc.?
SB: The key point there is technology. Collateral management has moved away from a process that can be supported on Excel to a process that requires sophisticated systems. Collateral management has also moved away from a process where operations did not matter to a process where operations matter a lot. What I’ve seen is that there are good islands of automation within a lot of financial practices, but there are no bridges that connect those islands of automation. What ends up happening is that one part of the process runs smoothly, but then there’s a manual re-key into another part, and that simply slows everything down. Data becomes more slow, settlement becomes slow, valuations become more slow.
What you need is to first have an operationally robust infrastructure that you put the right technologies on top of so that you can respond to these needs. Depending on what type of client you are and the jurisdiction you’re in, the timelines by which you need to think about these issues are going to be different. There’s a vast difference between the collateral needs, for example, of a Japanese bank and a European asset manager, and there are going to be different levels of sophistication that those institutions require, different technology, different counterparties, etc. So there’s not going to be one single solution that satisfies that diversity of clients or diversity of players in the derivative space. The key theme will be the right technology to ensure that you’re making optimal use of the collateral that you do have.
GC Friday Interview: Stephen Bruel, Global Head of Derivatives Product Management at BBH
Stephen Bruel, global head of derivatives product management at BBH explains how collateral management is evolving to address regulatory changes.