Getting Control By Untangling How Collateral Gets Managed
March 8, 2010
When Société Générale in 2008 divulged it had lost billions of dollars through an epic series of bad trades, executives attributed the damage to a single rogue employee.
But the Committee of European Banking Supervisors, a London-based watchdog group, found otherwise.
In a report issued in December, the supervisors said the bank's operational controls were, in short, a mess. "The failure of internal governance mechanisms, at multiple levels, was the main cause of the rogue trading event discovered at SocGen in early 2008," concluded the committee, whose membership is composed of banking regulators from the 27 European Union states.
"A close coordination between the control function (responsible for P&L and independent price verification) and the collateral management functions is necessary," added the report, in retrospect a profound statement of the obvious, even if in somewhat arcane terms.
The findings should reverberate with other financial firms, who no longer will find it easy to blame catastrophes like this on an individual. It's the firm's responsibility to make sure it controls and catches such risks, before the billions start to bleed away, and to maintain proper collateral management so that transactions can be carried out.
In the past, collateral management was a relatively manual and uncomplicated process.
The world has changed, however, and the speed of trading, the globalization of markets, the very complexity of modern portfolios has turned a once comparatively simple pencil-pushing process into a Byzantine electronic tangle. The very act of collateral management-keeping track of where collateral is housed, when it needs to be moved, whether counterparties are meeting their requirements-has created a market into which dozens of vendors have stepped.
Darren P. Measures, executive director and sales manager for clearance and collateral management at J.P. Morgan Chase, said buy-side firms in the securities industry in particular are going through what he called an "inflection point." The point: asset managers are facing unprecedented pressure from investors-and increasingly from regulators-to get their back offices in order by investing in better controls.
But many financial institutions simply lack the in-house expertise and resources to modernize their systems as thoroughly as they'd like. "The question so many of them are asking themselves," Measures said, "is should they farm it out to custodians? Should they employ third-party vendors?"
One of those "third parties" is J.P. Morgan Chase itself, which provides a wide range of services for managing the delivery and maintenance of collateral.
Under the broad rubric of collateral management, J.P. Morgan Chase, for instance, runs a cash repository for mortgage services, a third-party "lockbox" for collateral connected to borrowing between corporations, a hub for commercial-paper transactions, a post-trade settlement-and-clearing house for over-the-counter derivatives and more.
Measures maintains that the selling point for these services is that the customer can concentrate on trading, or other core competencies, while hiring the expertise to control front-, middle- and back-office risks.
The complexity of business at a typical securities firm, he noted, has grown by near-quantum measures in the past several years with the spread of high-frequency trading, options and other derivative securities, globalism and the creation of asset-backed securities.
John Avery, a partner at New York-based SunGard Consulting Services, said firms are making "initial investments," in modernizing the mechanisms they use in collateral management. Much of the improvement is meant to allow for executives to have better, more immediate access to collateral being exchanged and held, firm-wide, across asset classes and geographies. The aim is also to promote liquidity risk management by maintaining in essence a system of highly sensitive gauges on hundreds if not thousands of often rapidly-fluctuating positions, with the aim of making collateral available in the instant it's needed.
