RiskTech Forum

4Sight Whitepaper: Future trends in Optimization Collateral, Regulatory Capital &  CCP selection

Posted: 6 January 2014  |  Source: 4Sight

Financial firms are currently experiencing significant regulatory and cost pressures. This is leading to a search for ways to optimize various aspects of trade types that involve some level of counterparty credit risk (derivatives, securities lending, repo). 
This paper looks at the different types of optimization for these trades, how they are calculated, and how the different optimization groups are interrelated. It also discusses some of the practical aspects of this type of multivariate optimization.

A summary of the main trade optimization categories is below:

1.Regulatory Capital Optimization 

Basel III rules require banks to hold more loss absorbing tier-one capital, reduce leverage and maintain liquidity coverage ratios. Bank CEO’s and other senior executives are therefore looking at ways to optimise the use of capital and boost their firm’s return on equity. 
At a strategic level, this looks at which business lines are making the most P&L per unit of economic capital. As efficient use of capital improves profitability and return on equity, it then attracts more tier-one equity capital from investors. This is a key element in making banks an attractive investment compared with other industry sectors in an era when attracting capital is of critical importance but also more difficult.

2. Collateral Optimization 

Dodd Frank and EMIR regulations are increasing collateral costs through demand for high quality liquid assets for central clearing of derivatives. This has led to widespread use of collateral optimization solutions. 
These systems can help financial firms to reduce collateral costs by managing collateral supply and demand in an efficient way. Optimization also allows firms to make more effective use of eligible collateral assets sitting idle on the balance sheet.

3. Counterparty Optimization 

The move to central clearing is leading firms to think about which is the optimum counterparty to execute a trade with. For example, is it cheaper to execute a given trade bilaterally or with a CCP? If it is via a CCP, then which CCP is cheapest? Likewise, if the trade is bilateral, then which bilateral counterparty offers the lowest trade cost?

4. Trade Type Optimization 

Finally, there is trade type optimization. This looks at the difference in P&L that the firm can generate by deploying a security/cash in a securities loan, a repo, or using it to collateralise a derivatives trade. This process could also consider whether the firm should keep the security on its balance sheet to meet Basel III liquidity coverage ratios.

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