Towards a perfect environment for collateral?

Financial institutions have invested heavily in collateral over the past decade and brought many new innovations.

With the growth of machine learning and big data combined with the advent of quantum computing and distributed ledger technology, the pace of change across the collateral environment could rise exponentially.

But where is the industry heading, what could lead to a near perfect environment for collateral and what are the barriers to change today?

“The ideal is a situation in which there is seamless transfer between collateral supply and collateral demand,” says J.P. Morgan’s Michael Albanese. “It is one in which no one needs to search for an asset - if an entity needs a specific piece of collateral, it should be able to access it instantly.

J.P Morgan’s Graham Gooden adds: “Nirvana would be a fully-inventorised, priced and local pool of collateral and the ability to make automated decisions based on that. It is the ability to move a specific piece of collateral cost-effectively and efficiently with a frictionless transfer.”

Any future ‘nirvana’ has to be built on a strong foundation of asset safety and rigorous controls, which is critical to lenders and particularly important in times of crisis. Most people would agree with these visions for a perfect state.

A perfect collateral environment is a single pool of visibility and access, fully automated, exact selection and allocation, and instant and guaranteed settlement protected by a global legal structure.

It is one in which any asset can be transferred to and from any entity in the world instantly with no friction or counterparty risk. Deadlines for collateral calls would be a thing of the past as collateral would move automatically and in real-time.

The cost of collateral would be fully embedded into a trade and entitlement transferred in one Straight-Through Processing (STP) action with real-time and constant optimisation. In a default, the ownership of collateral would be instant and certain.

The question is how to get there and what are the major near-term barriers that need to be overcome first on the road to Nirvana.

The road to NIrvana

Albanese identifies four key areas that are currently holding back development. First is that firms remain able only to look within the confines of their own collateral management programmes.

“The perfect environment therefore is an all-to-all across all collateral agents globally,” he says.

Then comes the challenge of passing the book between timezones, a process that is becoming more common in the light of onshoring of financing among banks.   

“Increasingly because of Brexit or the realignment of legal entities in which desks are managed locally, the ability for banks to pass the books globally involving multi-step reuse or rehypothecation is ideal,” he says.

Third is the current system for moving cash between banks, which remains based on wire transfer and results in intense timing and deadline pressure to meet collateral calls.

Related to the inefficiencies inherent in moving cash and collateral, Albanese says, is the need to develop an intra-day market.

“As the cost of intra-day liquidity goes up, can we take some of the overnight and end of day principles of managing a good collateral eco-system and apply them to the intraday market? If someone needs cash for four hours or to borrow a security for three hours, they should be able to consider intra-day sec lending and intra-day repo,” he concludes.

That is a long way from where we are today. “There is friction across the whole cycle today. From agreeing the trade to the settlement of collateral there are frictions,” says Pirum’s Rob Frost. “The challenge becomes reducing those frictions process by process.”

Technology providers have a key role to play in that process. By mutualising the cost of advancement and acting as a neutral third party to link competing firms, vendors can intermediate and standardise processes.

As more of the cycle of collateral becomes standardised, the processes will become commoditised and the friction can be reduced.

From diesel to distributed ledger

BNY Mellon’s Mark Higgins compares the transformation underway in the collateral industry today to that in the automobile industry.

“The car industry is undergoing a transformation from combustion engines to electric vehicles. That involves a change not only in how cars are powered, but also a change in the infrastructure,” he says.

“I am not necessarily going to buy an electric car today because the infrastructure isn’t fully there yet in terms of charging stations etc. But I am pretty sure that I will be buying an electric car within the next 20 years.”

It is an interesting analogy. Electric car technology changes how cars function and improves a number of key metrics in the car industry such as efficiency and environmental footprint, two of the major concerns in the market today

In the same way, new technologies and processes in collateral management improve the efficiency and automation of existing processes.

But perhaps a larger change is underway in both industries.

For automobiles, the growth of automated driving technology could within the next 30 years completely change the very concept of driving.

We will still use cars to get from A to B but car ownership will be a thing of the past, the act of driving a rare past-time and entirely new infrastructures and networks will come to fruition.

In the same way, collateral management will still be used to collateralise an exposure with an asset, but the entire infrastructure could be unrecognisable from today.

If this change happens, DLT will be the driver. The tokenisation of collateral will be commercially available in the coming months, take-up will likely be slow initially but as people become familiar with the concept its use will grow.

However, it is the advent of smart contracts that will provide the most radical transformation. A smart contract is like a token in that it is a digitised record that sits on a blockchain. However, smart contacts also offer the ability to embed obligations and agreements bringing vast new opportunities.

As the technology is developed, the complexity and scope of what can be embedded within a smart contract will increase.

A collateral agreement signed as a smart contract linked to tokenised assets on the blockchain could automate the exchange of collateral ownership between counterparties in minute fractals of both units of collateral and seconds creating real-time, immutable and immediate transfer of collateral ownership.

In time, all aspects of a trade could be embedded within the contract. Counterparty risk would be overcome from the guaranteed and real-time settlement, reducing the barriers to the development of a truly all-to-all market.

Because all collateral across the industry can be stored in tokens on the blockchain, firms can search instantly for any asset and algorithms will automatically negotiate and execute smart contracts to secure any part of that collateral.

While this clearly represents a step-change in how collateral is processed, quite how disruptive this will be to current participants in the market remains to be seen. Current initiatives in finance are based around R3’s Corda and the Hyperledger initially designed by Linux.

These are both permissioned blockchains rather than the open blockchains that power bitcoin and other cryptocurrencies. Permissioned blockchains bring advantages in the fact that they don’t rely on the Proof of Work concept that powers the bitcoin blockchain consuming vast amounts of electricity to mine the coins.

It also secures the continuing importance of the incumbent intermediaries in the market who become the guardians of the blockchain and the source of the trust inherent in the technology.

Of course, there is a long way to go to get there and many doubts remain as to the potential of blockchain technology to achieve the nirvana. Questions remain over the speed, capacity and scalability of the technology itself.

There will also be different initiatives that move at different paces possibly leading to similar issues with interoperability that exist today. But it is clear to see how the concepts enabled by DLT could revolutionise the industry and the possibilities and capabilities of the technology will rapidly develop.

Bilgehan Aydin, head of collateral solutions at Commerzbank, says: “I don’t think that overnight you will have everything on blockchain but piece by piece you will have multiple blockchain environments that will have to communicate and form the new basis.”

“Ultimately, imagination is the limit.”

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