Funds Transfer Pricing and the Quest for Term Funding: Working Towards New Solutions

Funds Transfer Pricing (FTP) is emerging as not just a nice to have, helpful tool in managing a financial services business, but in some cases has become a regulatory necessity. FTP, also called Collateral Transfer Pricing in some firms, is the exercise of allocating the cost of liquidity between business units at the same firm. It is no longer enough to have a friendly handshake about cost allocation, especially when one desk is providing liquidity and another is a high-octane consumer.

The new requirement is that a robust model be in place that can show all internal participants as well as regulators how costs are allocated and absorbed. While FTP started with capital market activities, the next evolutionary step is in expanding the concept to include money markets, repo trading and securities lending activities. FTP is a reflection of the fact that term liquidity has become a finite and scarce resource that is not easy to manufacture for capital markets.

A Brief History of the Problem
Before the financial crisis, neither FTP nor collateral optimization played much of a role in financial institutions. The traditional model was that Treasury or an Asset/Liability Management department would match up both sides of the balance sheet. The Treasury team would link illiquid loans on the one hand and retail funding plus an equity component on the other hand, making trades to balance the difference and consider the matter closed. There was often no explicit cost of liquidity or collateral consumption to any trading desk, and certainly trading desks were not paid if they were net contributors to the overall collateral pool.

The traditional Treasury did not really understand the capital markets concept that can easily separate legal and economic liquidity mismatches, both on the asset as well as on the liability side of the balance sheet. This is in a way remarkable as exactly this mismatch is considered to be the Achilles heel of any deposit based banking system. But Treasury managers were not looking beyond banking deposits.

To illustrate the nature of the problem, we take an example of how capital markets assets were measured at the time. While the purchase of an asset causes a €100 million outflow and produces a legal mismatch of, say, five years, it does not show up with this mismatch on the liquidity radar screen of a treasury department (see Exhibit 1). The reason for this is that assets could be funded any day in the repo market, exchanged in the securities lending markets, or sold without a great loss under the assumption that there is ample liquidity and value at risk is relatively small.

Exhibit 1:
The pre-crisis view on capital market assets

Source: DekaBank

As a consequence, the outflow is 100% neutralized with a cash inflow and the mismatch disappears. The asset is now self-funded. Correspondingly, with no mismatch on the radar screen of the treasury and no long term funding impulse, there was a fair argument that a trader should only pay the repo rate as FTP or pay no more than EONIA / EURIBOR flat or equivalent based funding. This was all fine with high quality assets in very liquid markets, but might have gotten more complicated with less liquid securities. In essence the underlying assumptions were ultra-liquid assets, in ultra-liquid markets where neither market, nor funding, nor macroeconomic liquidity risk existed.

Moving closer to today, a laundry list of factors has emphasized the importance of FTP and collateral optimization and the technologies that accompany them. The factors we include are: recent regulations; balance sheet deleveraging; the increasing role of central clearing and CCPs; regulatory and central bank demands for transparency; internal auditors; and even internal trading desks when confronted with their funding costs. These have all increased pressure on Money Market, Treasury, repo, securities lending and collateral management departments to improve transparency on pricing and bring more rigour to their allocation methodologies.

Part of the new pricing paradigm are haircuts. While most people only had a limited understanding of haircut calculation before 2007 / 2008, today we find all kind of haircuts: central bank haircuts, LCR or NSFR haircuts, large exposure risk haircuts, VaR and gap risk haircuts, FSB haircuts, stressed and going concern haircuts, etc. Haircut calculations have become an art in itself and are an important driver of FTP or collateral optimization as they are used to inject longer term funding impulses into security positions, repo or securities lending and even structured or derivatives transactions.

Taking the same example from above, this trade is not only not self-funding, but it generates a strongly negative funding position (see Exhibit 2). Less liquid credit assets like NIG rated ABS, CLO’s, CDO’s or third tier equity, etc. now have a much more limited funding value. In this example they attract a 50% haircut. And what is more, this haircut gives rise to a €50 million negative liquidity mismatch, which shows up on the mismatch radar screen of the treasury and creates a long term funding impulse. With the cost of funds at 50%, a five year Asset/Liability Management curve and only 50% EONIA/market-based funding, it is obvious that the cost of liquidity has increased significantly for the holder of such a position. Accordingly, the trading position or instrument is not self-funding any longer.

Exhibit 2:
The post-crisis view on capital market assets

Source: DekaBank

Now, this would probably not be such a big issue if we had long term repo- or long term securities lending markets that would be able to manufacture term funding liquidity at reasonable cost. But currently, more than 80% of the securities lending and the repo markets are less than one month duration and offer no means to close negative funding mismatches in later time buckets.

As a consequence, haircuts have partially eroded the market and asset based funding system. Capital markets activities are now a term funding drag for the bank and are in competition for term liquidity with both, internal and external actors. Investment bankers are back to the negotiation table with the treasury department. In order to keep these negotiations from getting too unwieldy, a fair and transparent FTP methodology has to be implemented.

The Practice of Funds Transfer Pricing
FTP is the practice of allocating funding costs fairly across all parties. It is at heart a governance matter, ensuring that liquidity givers and takers are each compensated for their actions. As a governance process, FTP has four parts:

Liquidity Management
o Transparent liquidity reporting
o Make mismatches transparent
o Improve liquidity planning
o Ensure compliance with regulatory liquidity ratios
o Allocate cost of liquidity
buffers
P&L Management
o Determine P&L after Funding Cost
o Manage Funding Cost at Desk / Unit Level
o Determine Fair price for firm Liquidity
Balance Sheet Management
o Ensure efficient balance sheet utilization
o Help determine cost of balance sheet utilization
Pricing
o Determine fair transfer pricing between liquidity providers and liquidity users
o Determine correct LVAs for derivatives
o Ensure transparent liquidity prices

The hardest piece of FTP is actually figuring out how the pricing methodology occurs. Some firms have turned to market-based funding rates (repo and securities lending) while others use a haircut methodology. Some firms use a combination including taking haircuts from multiple internal and external sources. A 2014 white paper by SunGard, Finadium and InteDelta described a methodology for finding the fair value of an asset for FTP. With this collection of methodologies, it would come as no surprise that the FTP values across security types are a complex function of haircuts, funding and market liquidity and regulatory requirements (see Exhibit 3).

Exhibit 3:
A practical outcome of FTP for securities

Source: DekaBank

The exhibit shows an example for a level 2B security and a non-HQLA security. FTP decomposes any security position into different buckets of varying liquidity. The ultra-liquid parts may still be self-funded and attract a short term repo rate. The less liquid parts of a security position attract a higher portion of term money and thus higher costs of funding. In the below example, the Level 2B security attracts 50% funding at the one month bucket. The LCR haircut attracts funding at the three-month (internal or benchmark) rate, reflecting the fact that in order to neutralize the LCR impact you need longer term funding than just one-month. Eventually, there is also a longer term component (in this example illustrated by the ECB haircut), which attracts a one year funding impulse.

As can be seen in the exhibit, the non-HQLA asset attracts even 90% 3- months funding. The respective funding rates for the one, three or 12 months buckets may depend on the mix of funding instruments and access to funding markets for a certain institution (e.g. money market / deposit based funding, access to repo, CP, securities lending markets and other factors). It may be based on benchmarks like EONIA, EURIBOR or a mix of all the above. The methodology as outlined is relatively robust. As regulators inject even more long term funding impulses, e.g. through the NSFR, the methodology can be easily adopted.

Once you have proper funds transfer pricing for different collaterals as outlined, it is easy to construct FTP for repos by just adding or subtracting the term cash legs to the collateral leg. FTP for securities lending can be derived by adding / subtracting the FTP for the two collateral legs, or if that is easier and more direct by adding a repo and a reverse repo. As a consequence, you will have covered short term products in a straightforward, simple and transparent methodology that is both robust and flexible with regard to new requirements.

Regulators have made term liquidity both an essential as well as a finite resource of capital markets activities, despite the cash overhang created by QE in different parts of the world. This happened through simple measures like the de facto introduction of haircuts through of the LCR, NSFR, or by making it more difficult for beneficial owners to lend on term. As a consequence, costs of funds went up and financial institutions had to deleverage their balance sheet.

The Quest for Term Funding
The question is whether capital markets can create new sources of term funding to mitigate these effects. Repo CCPs may be a good starting point, however, with the exception of ultra-liquid government securities, which are self-funded anyway, term markets have not really developed there. Also, establishing term markets on a CCP is not a straightforward task. CCPs can change the collateral composition and counterparty risk requirements pretty much overnight, thereby invalidating the term nature of any transactions immediately. We are now discussing LCR baskets, but this is just an exchange of HQLA vs cash and will not do anything to generate term liquidity. Hence, what is good for systemic risk may be counterproductive for the development of secured term repo / securities lending markets. Bi-lateral transactions do work of course, but are not as balance sheet or capital effective as CCP transactions. That said, there have been some new ideas with regard to constant maturity type transactions recently. Eventually, term funding may be forthcoming from the shadow banking sector, but would this be in the interest of regulators and central banks?

Final Thoughts
Regulators as well as central bankers need to understand that by manipulating funding relevant haircuts (for instance by introduction of regulatory ratios like the LCR and NSFR), they can increase or decrease capital markets activity, respectively funding and market liquidity. Haircuts and market based funding levels are different sides of the same coin determining the internal and external cost of funds. Haircuts that are too high will exert funding pressures despite QE and prohibit market liquidity. Haircuts that are too low may lead institutions to leverage up their activities too much and add to too much credit sensitive assets to their trading books and balance sheets. Here, regulators and central bankers have some fine tuning to do.

Against this backdrop, FTP has become a requirement for any bank and capital markets division today. It is vital to have a fair and transparent methodology that allocates costs amongst liquidity givers and takers, thereby allowing institutions to price transactions according to their internal and external costs of funds. And here, banks have some optimization to do in steering and managing the supply of term liquidity that central bankers and regulators have allowed into the markets.

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Michael Cyrus
Head Short Term Products, Equity Finance & FX
Deka Investment – Germany

who will deliver a Presentation at our 5th Annual Collateral Management Forum. If you would like to receive more information please Request the Conference Agenda.

Panama papers: again, another reminder

The Panama Papers bring out several issues related to vulnerabilities of controls from countries and companies. We have heard about them…tax havens… offshore companies, banking secrecy, money laundering, political exposed persons… but what are they? How are they related to each other?

To start explaining, it is important to add another role as important as it is Internal Audit within the companies: the Compliance Officer. Where does it come from? What are their responsibilities?

After the most important financial scandals that took place in 2002 such as Enron and WorldCom the authority decided to tighten the nuts and the regulation changed. New rules were placed for public companies such as the prohibition of not being an auditor and consultant for the same company, disclosures if a company is dealing with a fraud, rotation of audit partners (5 years top), creation of the Audit Committee and how to protect whistleblowers among other things. And a new role emerges from this: the Compliance area.

Compliance as its name says it has the duty to comply with the law (externally) and with the policies and procedures (internally). Its difference with Internal Audit is to prevent rather than detect. As we all know either an external or internal Auditor determines a scope based on the nature of its revision in order to analyze what is being doing vs. what it should be. (For more information refer to the article, Value: Internal Audit) The bottom line: an auditor analyzes something that already has happened (after). Meanwhile compliance should be involved before taking a decision. (I.e. a contract, hire key staff, new provider, etc.)

Compliance should be in charge of manage the money laundering risk, which is defined as to give legality to money that comes from illicit activities. Those illicit activities are several among: traffic of drugs, human organs and humans. Prostitution, forgery, pornography, bribes, etc. The term “illicit” depends upon the legal framework of each country. The criminal will look for “paradises to launder money”…those countries or companies which can help him to launder lots of money at a low cost in a very quick time.

A tax haven is defined as a territory where taxes are levied at a low rate or has a system of banking secrecy. This means that banks are not allowed to give to the authorities the information of their clients… the real owner… is a “top secret” and it has to be kept as that, unless there is a criminal complaint. Offshore companies (legal entity), refer to be incorporated or register on tax havens.

Therefore, for its characteristics tax havens are used by some people for purposes of confidentiality…others for launder money and others to pay less tax or hide money from the IRS. The latest two mean a crime: tax evasion.

But tax evasion differs from money laundering. Although both are crimes they have specific characteristics. Therefore, depending on the circumstances, someone can be accused of both or just one.

Then there is another key concept: political exposed person…“PEP”. It is defined as someone who is or has been entrusted with a prominent function. Historically PEPs have shown us that tend to be corrupt. Taking bribes is illicit money; dirty money. It has to be laundered. Someone who is corrupt does not want to be known as such, so the money has to be seen as “clean”… as legal.

One of the key elements to deter and prevent money laundering is to know your customer (“KYC”) and apply customer due diligence. (“CDD”) Countries, authorities and companies need to know who the real owner is, as well as who controls. Criminals use among many methods:  shell companies, front man or identity theft to disguise its identity; therefore verify who really is the owner, it is an extremely important control.

Although there is still an investigation carried out in Panama, it reminds us (again) the importance of internal control that companies should have and countries should promote. How many factors have in common with the Enron case?

-Worldwide there are flaws in the laws that generate legal technicalities that help criminals or there are still issues to be regulated. In Enron case energy wasn't regulated. Today it is the offshore industry.

-In both cases there were rumors of corruption.

-Lack of transparency: Enron didn’t present a Balance Sheet meanwhile in Panama due to bank secrecy information is not provided.

-Enron used “mark to market” for accounting valuation and afterwards a “hypothetical future value” among the creation of several companies to disguise the fraud and real owner. (It included a trust). Today in Panama it is reported a number of companies created by complex structures, also.

-Statements from both executives of companies were: “we didn't do anything wrong”. The rationalization is the same.

Regardless of the mentioned above and the importance of controls and managing risks there is something more transcendent: values. Why do people even knowing that something is wrong, they do it?

And the history…again is repeated…with so much similarities…

By Mónica Ramírez Chimal, México

Partner of her own consultancy Firm, Asserto RSC:  www.TheAssertoRSC.com

Author of the books, “Don´t let them wash, Nor dry!” and “Make life yours!” published in Spanish and English. She has written several articles about risks, data protection, virtual currencies, money laundering. Monica is international lecturer and instructor and has been Internal Audit and Compliance Director for an international company.

UNDERSTANDING THE RISKS OF CYBER CRIME

Technology has changed the way we bank. Today there are plenty of ways to do our banking easier than ever which is great for customers and organizations but it also presents new ways for cyber criminals to try stealing important data or money. Financial businesses are prime targets but as banks are strengthening and securing their systems, making it more difficult to breach in, there is an increased interest in targeting the customers.

“Governments, industries and companies all need to work closer together to tackle increasing cyber attacks. While recent government cyber-initiatives in the US and UK are welcome, there needs to be better coordination between governments and moves towards more consistent and uniform global regulation if cyber attackers are to be caught and punished. Similarly, there needs to be greater co-operation and sharing of information between (and within) industries and among companies to combat cyber risk effectively.” (Lloyd’s 360°Digital Risk Report)

It is impossible to completely eliminate cyber threats, so it’s essential to ensure cyber security and protection against them to keep the online economy running without major disruptions in business innovation and growth. Understanding and acknowledging the risks of cyber crime is crucial.

What are the risks of cyber attacks according to Lloyd’s 360°Digital Risk Report?

• Operational risks – loss of service to customers, loss of data, loss of the internal network, or interruption to supply chains.
• Financial risks – result from operational risks, fraud and theft, loss of customers and sales
• Intellectual property risks – the loss of intellectual property and business plans which can result in the loss of competitive position in the market
• Legal and regulatory risks
• Reputation risks –  loss of confidence and trust in the company, damage on the company’s brand, image and reputation.

In today’s digital world we are more dependent on IT and the internet than ever before and this trend is most likely to be continued in the future. Technology makes accessibility and connectivity rather easy these days which increased the exposure to digital risks and cyber crime. This gives enough reason to be prepared and more aware, make the necessary precautions to reduce the risks or even prevent these attacks.

FINDING THE RIGHT OUTSOURCING PARTNER

Continuing the outsourcing topic, let’s see what factors you should consider when choosing an outsourcing business partner.

First the process, service or product needs to be determined that your organization want outsourced and the goals you want to reach through outsourcing. Once it’s done you can start looking for the ideal business partner that meets your criteria best, which can result in a beneficial partnership.

Finding the right external vendor can be challenging and it may take some time but a carefully made decision can minimize any delays or problems that may occur later. The chosen outsourcing business partner should be reliable and have strong core values. Qualities like efficiency, integrity, expertise, and great communication skills. Working with a well-selected service provider can result in saving money and time, enhanced speed to market and product value, streamlined business processes, increased net worth and growth for your organization etc. It can give your business a competitive edge.

Here are some key factors to be considered

1. Track record and references: Ask for references. Check if the potential outsourcing partner has proven track record of different types of projects that they have successfully completed. Find out more about their expertise and experience in the services you want outsourced to see if they are suited for your business needs.  
2. Service quality: Check if your prospect has a quality assurance system and what kind of service level agreement they are offering.
3. Communication - Language and cultural compatibilities: Good communication results in a better outsourcing relationship. Make sure that your partner is available and easily accessible 24/7 any day of the year. Time zone differences and distance can cause difficulties in control. Ensure that you and your vendor speak the same language and are culturally compatible. Language barriers and different corporate culture can also result in problems.
4. Data protection, security: Ensure that security and confidentiality of your data is well-maintained. This is crucial if you don’t want data leakage or breaches to happen.
5. Skilled resources: Reliable outsourcing business partners have experts on their team with the right skills and qualifications. They would work on your projects with the help of the latest technologies provided resulting in error-free solutions and efficiency.

Conclusion

There are many other factors to be looked out for (e.g.: affordable costs, pricing, flexibility, free trials etc.), these were just some of them pointing out the importance of a well-thought-out and carefully made decision. Choosing an outsourcing partner is not a process to be rushed if your company wants to end up with the best vendor that meets your requirements and service level. Outsourcing to the right service provider can save you time and cost, increase revenue and enhance productivity among many other advantages.

OUTSOURCING DILEMMA - PROS & CONS

Outsourcing is still a hot topic these days for organizations. It is an allocation process of specific business processes to an external service provider. Once the tasks are outsourced to 3rd parties, it will be their responsibility to carry out those tasks, maintain the company’s assets. Outsourcing has many benefits that can be leveraged but disadvantages should be considered prior to assigning any component of the organization to an external vendor.

Benefits of Outsourcing

• Lower recruitment and operational costs
• Access to foreign market
• Access to better technologies at a lower cost
• Vendor expertise - tasks can be carried out faster, more effectively and often with better quality
• Improvement of productivity, efficiency and service quality in-house
• Competitive edge in the market against competitors who have not yet considered outsourcing
• Concentration on core competencies and process

Disadvantages of Outsourcing

• Hidden costs
• Risk of exposing confidential/classified information that can bring a threat to the company’s security, privacy and confidentiality
• Serious problems and difficulties if the chosen service provider refuses or can’t finish work for different reasons e.g.: lack of labor, lack of funds or even bankruptcy
• Lack of communication
• Possible loss of management and control over the outsourced processes
• Lack of customer focus - the service provider can be working for multiple companies at the same time. This could very well mean that your company’s tasks may not be done with the outsourced partner’s complete focus.
• Cyber-crime threats

It is very important to consider all the advantages and disadvantages before actually choosing a 3rd party vendor but it is also crucial to the company’s success to find the right service provider. If you make your decision carefully then you can leverage on the benefits that outsourcing can provide and these advantages will weigh out the possible disadvantages that can be avoided by choosing the right partner.

LEAN BANKING: BANKING WITHOUT WASTE

Lean comprises a philosophy or way of thinking that seeks the elimination of waste processes in organizations. Waste is anything that does not add value, such as: transport files from one location to another, the timeout records in the input or output tray, and the execution of unnecessary activities. Companies throw a lot of money to garbage can, through work practices that do not add value. By implementing Lean, organizations make large sums of money from the trashcan. Lean has a set of proven techniques for improving productivity tools, quality and response times. These tools and techniques are focused on creating a continuous flow, standardize inputs to reduce variability in processes and achieve greater operational flexibility.

 

This article describes the benefits that Lean offers banking, guidelines for successful implementation and how it can be used to develop a sustainable competitive advantage.

 

 

Benefits of Lean for Banking

 

International research reports that banks have introduced Lean techniques in its processes have cut costs by up to 30%, in addition to reduced delivery times and errors up to 80%. Its benefits are well documented in banking and in a wide variety of economic sectors:

 

• Improving profitability by increasing productivity and reducing costs.
• Decreased percentage of defects and improving service by reducing response times and errors.
• Increased revenue by allowing more time for sales at banks and other service companies.
• Greater involvement of staff.
• Mitigation of operational risk by standardizing processes and work practices.

Adopting Lean is to assume a new way of organizing or revise operational processes. It is a different way of running a business or institution. Only applying it to some of their practices is losing the ability to develop a sustainable competitive advantage.

 

The banks that have implemented Lean insurance have accelerated their loan approval processes, decreased operating costs, or increased time for sale reorganized its offices. These new capabilities, for example, allow you to increase sales while maintaining relatively low costs, lending to power faster and allow more time to sell in their offices.

 

The formation of cells in loans, customer or account processing creates a continuous flow, accelerating response times and reducing the error rate. Improvements in the processes of "backoffice" allow faster response to offices, as well as release staff in contact operational workload. The reorganization of offices and cross training allows more time for sales.

 

In general, any other bank implementing Lean Banking can achieve similar results obtained by the pioneers. To the extent that the other banks adopt these changes in their operations, response levels are similar, as are the costs and quality indicators. However, it will depend on the ability and innovation of its management and employees to use these new capabilities to gain market share profitably or continue to reap greater profitability of the operation to develop a continuous improvement program.

WILL BRANCHES DISAPPEAR SOMETIME?

With the growth of electronic and digital channels, the banking industry is constantly debating about: WILL BRANCHES DISAPPEAR SOMETIME?

Brett King, author of the bestseller Bank 2.0 (and its recent sequel, Bank 3.0) seems to predict the disappearance of bank branches, particularly in his book "Branch today, Gone tomorrow". After all, in a world where the virtual seems to move inexorably on the physical it does not sound illogical: how many libraries around the world have disappeared because of Amazon, video-clubs, mail (at least for letters), traditional encyclopedias …

And this seemed to be accompanied by statistics of branch closures, along with the desire of bankers to reduce the cost per transaction, clearly much higher in care "face to face" in the self-service channels and essentially digital ( web and mobile in particular).

However, recent figures show, for example in the United States what appears to be a reversal in this trend. After three years (2010, 2011 and 2012) where there were more closures than openings of new branches, in 2013 banks in the United States opened more branches in total than were closed (according to the figures of the FDIC). Banks opened in the US in 2013 a total of 3,000 branches, the highest number since 2009.

It should also be noted that there was a process of mergers and acquisitions that accelerated the closure of branches in this period. Does this mean a return to the personalized attention to the detriment of the digital channels?

I believe that definitely not. But in my opinion this indicates that the new user ("omni-user"?) does not think as yet it is widely believed in the industry: in channels. The user wants to choose according to their need, the time, place and their own tastes and how, when and where styles interact with banks. And this clearly includes branches. What this new model of user definitely does not want is that banks impose them to go to a branch for a particular transaction. But sometimes, some users require personal assistance than any other "channel" can´t provide as good as branches.

Brett King himself, as disruptive analyst - and by the way such as founder and CEO of a bank 100% virtual (www.moven.com) in a closer reading, attributed to the branches a role within the customer care strategy, not their complete disappearance. Of course, with a strong impact on the branch model to deploy. Eventually the branch must be an interaction point with a very specific purposes, perhaps the most precious resource for resolving situations of certain complexity or sensitivity, while a model of differentiated attention and addressed to groups of users who have special characteristics, tastes and needs.

In short, I believe that the branch should become a point, consistent with the design of user experience interaction, not a silo. You should be prepared for integration with other channels, be flexible to adapt to the characteristics of the user groups for which it is designed and operate with maximum efficiency.