The derivatives market is by far the largest financial market in the world. It has been estimated that if all the outstanding derivatives in the world were combined, their value would easily exceed world GDP by a wide margin. What isn’t as widely talked about is the role that collateral management plays in derivatives trading, and how much work is involved in ensuring that counter party risk is mitigated by effective use of collateral.

One of the largest issues that the industry faces is the way that accounting has developed in derivatives trading operations. In general, when derivatives are traded there are two separate entities involved within one side of a trade; a trading group, and a settlement group. The trading group is often referred to as the front office, and the people responsible for settling the trade are referred to as the back office.

Collateral management is usually done by the back office, and this is where delays and inefficiencies enter the equation. Because the person or group entering the trade is relying on a lagging mechanism to ensure regulatory compliance, and safety, there are a number of challenges that can emerge in settling derivatives trades. Moreover, the current collateral management systems that are in place aren’t as efficient as they could be, and these inefficiencies represent lost profits.

Banks and other trading entities need to not only protect the financial system to the greatest degree possible, they also have the duty to maximize shareholder value. This means taking a look at collateral management and trade settlement systems with new eyes, and removing any roadblocks to a safe, efficient system.

Murky Water

While trading operations move at the speed of electrons, the settlement systems and collateral management systems are relative dinosaurs. The fastest collateral management systems in place today are settled on a daily basis, and this is a very new development. Until the crisis in 2008, there weren’t any industry wide regulations for how collateral was used to offset the risk from derivatives trading, and this was a big problem when the synthetic bonds that were almost universally held became problematic to value.

The problem with collateral management is two-fold. Firstly, the system that trading entities use to ensure adequate collateral is slow and outdated. Secondly, there is no worldwide central clearing mechanism for ensuring that the same security hasn’t been pledged as collateral to two (or more) counterparties. Because the systems used for derivative trading evolved in a piecemeal fashion, the derivatives industry is in a position where innovation is necessary to build confidence, and avoid another systemic crisis.

Benefits To Growth

The risks to the world economy from ineffective collateral management in the burgeoning derivative market are now obvious. But for industry a more efficient system holds promise for both operational dynamism, and the creation of cost savings. Because the collateral management system that is currently used is both slow, and potentially ineffective, it requires more labor than necessary.

Part of the solution for this conundrum is a movement away from traditional bookkeeping methods, and also the creation of a world clearing house for any securities that could be used in the derivatives market. If all the securities that could be accepted as collateral were cataloged, it would disrupt the need for complex back office settlement.

Prior to 2008 the kinds of collateral that were suitable for derisking trades was much wider, but today, there are industry standards that are slowly being phased in. So while a clearing house based solution wouldn’t have helped the world avoid the crisis in 2008, today it is a completely realistic direction for industry.

As automation has shown in other industries, when a people are removed from a system, the increase to profits can be substantial. While the front office trading operations are likely at a level that isn’t going to be improved upon by additional automation, the back office settlement and collateral management systems are a perfect sector to explore opportunities to cut costs, and remove potential systemic risks.