J.P. Morgan manages more than $1 trillion of collateral assets worldwide, and 19 of the top 20 broker-dealers use its collateral management services. Kelly Mathieson, the global head of collateral management and clearance at J.P. Morgan Worldwide Securities Services talks to <i>FinanceAsia</i> about the importance of collateral assets being liquid and other key issues.
What is collateral management?
Collateral management is a set of solutions that help to manage collateral provided or taken by two parties who have agreed to a bilateral trade, and who require support for their risk management activities. The provision of collateral secures a transaction, and that collateral can take many forms, including securities, derivatives or cash (usually for regulatory purposes). Third party agents don't decide what type of collateral should be provided by the cash borrower or the overall collateral mix; instead that is determined bilaterally by the provider (or borrower) and the taker (or lender). An agent can optimise the use of collateral posted by the borrower and support the risk management needs of both parties to a transaction
What particular advantages do third-party firms provide in managing individual firms' collateral exposures and positions?
As trading activities have become increasingly complex, encompassing more markets, financial instruments, counterparties and webs of bilateral transactions; and as markets have also become more volatile, so the support and management of collateral has become a more complex undertaking. The whole system is now massive, requiring specific quantitative tools and skills which require considerable investment. So, increasingly, financial institutions are turning to third-parties, in effect outsourcing the task to agents, which have the necessary expertise, resources and controls. A third party has the further advantage of scalability and offers a robust, dedicated platform.
Has collateral management become more important since the implosion of markets year ago?
A key lesson learned from events in 2007 and 2008 is that collateral is only as good as its liquidity -- that is the ability to sell it and make a counterparty whole -- when there is a risk of default by the other counterparty during crisis conditions for securities markets. But although that is easy to see in hindsight, anticipating that difficulty in the future is far more problematic and requires a detailed assessment of the type, quality, location and accurate pricing of collateral -- including calculating necessary discounts or "haircuts". And the collateral mix -- its diversity or concentration, takes on greater importance. Rather than treating each piece of collateral separately, in order to evaluate and monitor overall risk exposures, it is essential to aggregate collateral provided by counterparties in a multitude of trades. Not least of the lessons, painfully learned by some, is the absolute requirement for collateral to be held in bankruptcy-remote accounts, fully and legally segregated from a counterparty's other accounts.
What new developments are taking place?
We have been very busy and vocal pushing for reforms to a system which had largely evolved on an ad hoc basis. Disputes over margin calls for collateral, for instance, had become common, exacerbated by a primitive messaging system between counterparties. ISDA (the International Swaps and Derivatives Association) has started work on a dispute resolution protocol in an attempt to streamline these manual processes and ensure agreement about prices, and an industry electronic messaging platform is also under development.
More efficient systems are increasingly important as borrowers look to increase their number of counterparties in the wake of the failure of Lehman Brothers in September 2008. Even before then, we had recognised a need for a global collateral platform that would allow clients to see their positions in real-time across geographic regions and legal jurisdictions.
Who uses your services?
Banks, broker dealers, asset managers and other financial institutions are active in collateral taking and providing. They turn to us because setting up a sophisticated and robust platform is expensive, time-consuming and requires many human resources at least in setting it up. We are now the world's premier provider of collateral management services, with rapid and efficient automated systems in place to monitor and manage collateral positions.
How do you and other providers of these services make money?
Fees are charged based on the size of any deal, and are measured in basis points. They cover the total value of the collateral, and vary according to security and market type.
Is Asia a relatively new territory for your firm?
Over the last couple of years, we have been developing long-term relationships with financial institutions throughout the region, offering our whole menu of collateral management functions and services. We have a full operational capability in Hong Kong, Sydney and Tokyo, and will shortly have the same in Manila. Our other regional offices -- in every major Asian country -- also have support capabilities. We believe that it wouldn't make sense to run our Asian collateral management business out of New York.
How do you envisage the business will grow?
This year, the business trajectory should be quite straightforward, with investors and other financial firms bolstering up their risk management systems in the wake of the financial and credit crises. That will include outsourcing more of their collateral management operations to banks such as J.P. Morgan. But, there is unlikely to be much change or growth in the type of securities or derivatives requiring collateral, or in the nature of securities or derivatives provided as collateral.
However, 2010 promises to be exciting. Markets are turning better, confidence is returning and lenders are coming back and extending credit lines. Activity in derivatives, for instance, should enjoy tremendous growth next year. Meanwhile, the impetus for the creation of rigorous and consistent models in which collateral management operates will move ahead rapidly, led by a highly motivated ISDA.
