Evolution not revolution: The developing collateral and liquidity landscape
29 October 2024
With the shifting landscape of global regulation and the US move to T+1, State Street鈥檚 Sam Edwards, head of Collateral EMEA/APAC and Global Triparty Services, and Greg Donovan, vice president of Collateral Client Solutions, look at collateral management and the importance of DLT
Image: State Street
The need for market participants to enable all inventory for use as collateral, alongside the ability to mobilise and deploy that collateral at ever increasing speeds has never been greater.
The acceleration of T+1 settlement cycle practices across global markets places increased pressures on inventory availability, most prevalently in the US market, but also with other markets, including those most commonly used in securities financing transactions, set to follow suit in close order. The approaching milestone of mandatory US Treasury clearing looks likely to bring as many as 7,000 new intermediary-indirect participant relationships into scope. Global Uncleared Margin Rule (UMR) regimes continue to place demands for initial margin on market participants brought into scope during Phases 1-6, with additional entities falling into scope each year during the monitoring cycles for each respective regulatory jurisdiction.
A series of market volatility shocks since early 2020 have demonstrated the rapid constriction of cash and high quality liquid assets (HQLA) availability that can impact market participants in short timeframes, as well as the procyclical impacts these constrictions can have on the underlying assets, as demonstrated most clearly during the liability-driven investment (LDI) UK gilt crisis in October 2022. The importance of effective and efficient collateral and exposure management has never been clearer.
Collateral management functions, such as meeting exposure obligations, and liquidity management, ensuring 鈥榬ight asset, right place, right time鈥� to enable best financing outcomes, have always been closely aligned concepts and operations. Against this increasingly complex and dynamic market backdrop, however, there is a need to acknowledge the inherent interplay between them with the need to have robust, tested, scalable solutions that facilitate optimal outcomes across both the fulfilment of collateral obligations and the management of liquidity and funding. It is why the market trend towards outsourcing continues, as service providers offer the scale, expertise and technology to deliver for firms of all types and sizes.
There is increasing directional momentum across the buy side, sell side, as well as service and technology providers, which suggests that distributed ledger technology (DLT) is the logical next step for solutioning around these two inextricably linked processes. The possibilities that it offers with regards to settlement certainty and velocity are highly attractive in our modern environment where certainty is key and time lapses are costly. DLT presents a future with 24/7/365 inventory deployment across geographies, unconstrained by the inconsistencies of traditional market settlement apparatuses. Collateral managers, treasury managers and financing providers 鈥� freed from the restrictions of mobilising assets and cash across existing silos 鈥� will be able to instantaneously monitor and meet collateral and funding obligations, eradicating burdensome operational overheads and exponentially reducing counterparty risk in the process.
How realistic, however, are these expectations? How robust, tested and scalable are the DLT solutions that seem to offer so much? Do they represent a panacea for all matters relating to collateral and liquidity management? Will they arrive in time and at scale to sufficiently help market participants meet the increase in demands that are being placed on them?
As with all technologies, it is not the fundamental construct of the technology itself which is determining the answers to these questions but, rather, the way in which its providers and users are adopting and deploying it. The motor car would have remained a curious oddity had improvements in manufacturing processes and road infrastructure not been developed alongside it. There is a need to acknowledge that DLT solutions are not set to fulfil their evident promise overnight and will not stand entirely separate from the existing infrastructure of global capital markets.
With the total value of global collateral in circulation approaching US$30 trillion, there is a need to capitalise on the scale of existing technologies to expand available pools of collateral and to mobilise and deploy that collateral at increased speed. At State Street we believe that the provision of a scalable and robust DLT solution that is integrated with 'best-in-class' established technologies can fundamentally transform the mobilisation of collateral on behalf of our clients and the onward movement of that collateral to their counterparties. This can, in turn, improve the liquidity risk profile and processes of our clients. We are excited at the opportunities that the synergies provided by our DLT and established technologies are set to unlock for our clients in both of these areas.
The case for digital solutions: Think big
Collateral DLT solutions are currently being used on a small scale. One or two tokenised money market funds (MMF) delivered to a single counterparty here; a currency or two delivered cross-border between branches of the same bank using a stable coin there. These individual undertakings are no mean feat, in and of themselves, and deserve recognition for the innovative use of technology that they represent. But how do we, as collateral and liquidity service providers, scale these DLT concepts up in order to genuinely meet the requirements of a global marketplace with US$30 trillion of collateral being managed on a daily basis? How do we ensure that DLT can be an important and relevant piece of the collateral and liquidity solution of the future?
The answer is to deploy DLT to transform collateral settlement into a digitised instantaneous event between market participants. In essence, the future of collateral mobilisation and delivery is akin to the digitisation of settlement within a triparty environment but with less operationally intensive processes for the funding of that environment. The core benefit of triparty is that it enables asset concentration and optimisation of inventory allocation across exposures. For decades we have seen the benefits it has brought through the elimination of individual bilateral settlement and the codification of 鈥榖est鈥� to deliver.
A key challenge for users of triparty, however, is the mobilisation of sufficient (and sufficiently well diversified) assets into the environment to meet the aggregated liabilities across their collateralised agreements. The need to move assets from a primary custodial environment (or, sometimes, from several) to that of a triparty provider is a major source of cost and operational friction for clients. This is particularly true for buy side participants who tend to have more constrained and siloed pools of inventory available for delivery into triparty when compared with their sell side counterparties.
State Street envisions a DLT enabled collateral environment that would facilitate seamless settlement across all asset classes. This deploy's 'best-in-class' capabilities for optimising inventory selection and deployment across all exposures, as well as leveraging smart contract capabilities in the coding of optimisation rules, in order to further reduce friction in the collateral process. The ability to digitally enhance the onboarding, contract creation, agreement amendments and user interaction model will accelerate the adoption of the new capabilities. The overarching principle is for clients to be able to conduct their trading and collateral activities within one custody environment.
'Best-in-class' inventory optimisation solutions are used to manage the selection of inventory from the client鈥檚 custody accounts into a digital wallet based on aggregated requirements across all their exposures. Assets can be reflected as tokens through the minting mechanism of the DLT, ready for instant delivery to counterparties. Optimisation capabilities can determine efficient allocation of collateral across all counterparty exposures, based on the matching required values (RQVs) received, and established agreement parameters relating to eligibility, haircuts and concentration limits. Instantaneous, frictionless settlement of the tokens occurs between the client鈥檚 digital wallet and that of each counterparty. Any returns, recalls or substitution of assets out of the environment can automatically result in the burning of the corresponding tokens and release of the collateral from the digital wallet, with replacements, where necessary, automatically selected by the inventory optimisation engine based on predefined parameters.
This model does not need to be limited to MMFs, a common first use case for the market, or digitally native assets. It will, however, enable efficient use of assets, such as MMFs, that are not currently fully deployed as collateral, expanding the pool of available collateral. More broadly, it should empower clients to deploy any eligible asset that they hold against any of their exposures and for collateral eligibility to continue to expand as liquidity and reuse of new assets grows. That is not to say that there will not be work to do in order to provide market participants and their counterparties, their respective lawyers, risk managers and credit risk functions with the comfort that they need in order to deploy digital collateral at scale. This is, however, a vital conversation as this solution will help meet those twin needs of collateral and liquidity management in the modern age. Readily mobilising assets without the associated operational burdens; creating liquidity and enabling asset reuse; and delivering the instantaneous and frictionless settlement of assets across DLT to enable cross liability collateralisation is a technology challenge that State Street is embracing.
The acceleration of T+1 settlement cycle practices across global markets places increased pressures on inventory availability, most prevalently in the US market, but also with other markets, including those most commonly used in securities financing transactions, set to follow suit in close order. The approaching milestone of mandatory US Treasury clearing looks likely to bring as many as 7,000 new intermediary-indirect participant relationships into scope. Global Uncleared Margin Rule (UMR) regimes continue to place demands for initial margin on market participants brought into scope during Phases 1-6, with additional entities falling into scope each year during the monitoring cycles for each respective regulatory jurisdiction.
A series of market volatility shocks since early 2020 have demonstrated the rapid constriction of cash and high quality liquid assets (HQLA) availability that can impact market participants in short timeframes, as well as the procyclical impacts these constrictions can have on the underlying assets, as demonstrated most clearly during the liability-driven investment (LDI) UK gilt crisis in October 2022. The importance of effective and efficient collateral and exposure management has never been clearer.
Collateral management functions, such as meeting exposure obligations, and liquidity management, ensuring 鈥榬ight asset, right place, right time鈥� to enable best financing outcomes, have always been closely aligned concepts and operations. Against this increasingly complex and dynamic market backdrop, however, there is a need to acknowledge the inherent interplay between them with the need to have robust, tested, scalable solutions that facilitate optimal outcomes across both the fulfilment of collateral obligations and the management of liquidity and funding. It is why the market trend towards outsourcing continues, as service providers offer the scale, expertise and technology to deliver for firms of all types and sizes.
There is increasing directional momentum across the buy side, sell side, as well as service and technology providers, which suggests that distributed ledger technology (DLT) is the logical next step for solutioning around these two inextricably linked processes. The possibilities that it offers with regards to settlement certainty and velocity are highly attractive in our modern environment where certainty is key and time lapses are costly. DLT presents a future with 24/7/365 inventory deployment across geographies, unconstrained by the inconsistencies of traditional market settlement apparatuses. Collateral managers, treasury managers and financing providers 鈥� freed from the restrictions of mobilising assets and cash across existing silos 鈥� will be able to instantaneously monitor and meet collateral and funding obligations, eradicating burdensome operational overheads and exponentially reducing counterparty risk in the process.
How realistic, however, are these expectations? How robust, tested and scalable are the DLT solutions that seem to offer so much? Do they represent a panacea for all matters relating to collateral and liquidity management? Will they arrive in time and at scale to sufficiently help market participants meet the increase in demands that are being placed on them?
As with all technologies, it is not the fundamental construct of the technology itself which is determining the answers to these questions but, rather, the way in which its providers and users are adopting and deploying it. The motor car would have remained a curious oddity had improvements in manufacturing processes and road infrastructure not been developed alongside it. There is a need to acknowledge that DLT solutions are not set to fulfil their evident promise overnight and will not stand entirely separate from the existing infrastructure of global capital markets.
With the total value of global collateral in circulation approaching US$30 trillion, there is a need to capitalise on the scale of existing technologies to expand available pools of collateral and to mobilise and deploy that collateral at increased speed. At State Street we believe that the provision of a scalable and robust DLT solution that is integrated with 'best-in-class' established technologies can fundamentally transform the mobilisation of collateral on behalf of our clients and the onward movement of that collateral to their counterparties. This can, in turn, improve the liquidity risk profile and processes of our clients. We are excited at the opportunities that the synergies provided by our DLT and established technologies are set to unlock for our clients in both of these areas.
The case for digital solutions: Think big
Collateral DLT solutions are currently being used on a small scale. One or two tokenised money market funds (MMF) delivered to a single counterparty here; a currency or two delivered cross-border between branches of the same bank using a stable coin there. These individual undertakings are no mean feat, in and of themselves, and deserve recognition for the innovative use of technology that they represent. But how do we, as collateral and liquidity service providers, scale these DLT concepts up in order to genuinely meet the requirements of a global marketplace with US$30 trillion of collateral being managed on a daily basis? How do we ensure that DLT can be an important and relevant piece of the collateral and liquidity solution of the future?
The answer is to deploy DLT to transform collateral settlement into a digitised instantaneous event between market participants. In essence, the future of collateral mobilisation and delivery is akin to the digitisation of settlement within a triparty environment but with less operationally intensive processes for the funding of that environment. The core benefit of triparty is that it enables asset concentration and optimisation of inventory allocation across exposures. For decades we have seen the benefits it has brought through the elimination of individual bilateral settlement and the codification of 鈥榖est鈥� to deliver.
A key challenge for users of triparty, however, is the mobilisation of sufficient (and sufficiently well diversified) assets into the environment to meet the aggregated liabilities across their collateralised agreements. The need to move assets from a primary custodial environment (or, sometimes, from several) to that of a triparty provider is a major source of cost and operational friction for clients. This is particularly true for buy side participants who tend to have more constrained and siloed pools of inventory available for delivery into triparty when compared with their sell side counterparties.
State Street envisions a DLT enabled collateral environment that would facilitate seamless settlement across all asset classes. This deploy's 'best-in-class' capabilities for optimising inventory selection and deployment across all exposures, as well as leveraging smart contract capabilities in the coding of optimisation rules, in order to further reduce friction in the collateral process. The ability to digitally enhance the onboarding, contract creation, agreement amendments and user interaction model will accelerate the adoption of the new capabilities. The overarching principle is for clients to be able to conduct their trading and collateral activities within one custody environment.
'Best-in-class' inventory optimisation solutions are used to manage the selection of inventory from the client鈥檚 custody accounts into a digital wallet based on aggregated requirements across all their exposures. Assets can be reflected as tokens through the minting mechanism of the DLT, ready for instant delivery to counterparties. Optimisation capabilities can determine efficient allocation of collateral across all counterparty exposures, based on the matching required values (RQVs) received, and established agreement parameters relating to eligibility, haircuts and concentration limits. Instantaneous, frictionless settlement of the tokens occurs between the client鈥檚 digital wallet and that of each counterparty. Any returns, recalls or substitution of assets out of the environment can automatically result in the burning of the corresponding tokens and release of the collateral from the digital wallet, with replacements, where necessary, automatically selected by the inventory optimisation engine based on predefined parameters.
This model does not need to be limited to MMFs, a common first use case for the market, or digitally native assets. It will, however, enable efficient use of assets, such as MMFs, that are not currently fully deployed as collateral, expanding the pool of available collateral. More broadly, it should empower clients to deploy any eligible asset that they hold against any of their exposures and for collateral eligibility to continue to expand as liquidity and reuse of new assets grows. That is not to say that there will not be work to do in order to provide market participants and their counterparties, their respective lawyers, risk managers and credit risk functions with the comfort that they need in order to deploy digital collateral at scale. This is, however, a vital conversation as this solution will help meet those twin needs of collateral and liquidity management in the modern age. Readily mobilising assets without the associated operational burdens; creating liquidity and enabling asset reuse; and delivering the instantaneous and frictionless settlement of assets across DLT to enable cross liability collateralisation is a technology challenge that State Street is embracing.
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