Focus: Collateral transformation
Source: Getty Images
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The
shape shifters
Regulations on collateral requirements are forcing firms
to seek to transform what they already have into assets
that will work better for them, writes Tracy Alloway
the markit magazine – Winter 2011
Focus: Collateral transformation
I
t’s a year until central counterparty
clearing, the post-crisis financial
reform mandated by regulators
and politicians, begins to take hold
for buy-side users of derivatives.
But already the planned move has
given birth to a new type of business, with many dealers and custodian banks aiming to offer “collateral
transformation” to their large institutional customers.
The idea behind the service is simple.
With central clearing comes the need
for trillions of dollars worth of collateral
– high-quality securities which buy-side
firms might be lacking. Instead of such
funds having to purchase new assets
or liquidate their portfolios to meet
collateral requirements, some banks
plan on offering to convert the funds’
existing securities into cash or government bonds.
“With new regulation and the move to
central clearing, there will be more of a
need for the collateral deemed eligible
by clearinghouses,” says Christopher
Coleman, business manager at BNY
Mellon, the world’s biggest custodian
bank. “We continue to explore the most
appropriate solution to help clients
source the required collateral.”
But while the concept may seem
simple, some market participants say
collateral transformation obscures a
problem rather than solves it. Moreover,
the push for more high-quality collateral could even change the mechanics
of the wider repo market, where banks
and buy-side firms lend out trillions of
dollars worth of securities every day.
As part of Dodd-Frank legislation in
the US and new rules in Europe, buyside users of over-the-counter derivatives
will eventually be required to run their
trades through central counterparties, or
CCPs. The idea is for the CCP to stand
between the parties in a derivatives
trade, making the global financial
system more secure and bringing additional stability to the derivatives market.
However, in order to make the CCP
itself safe, the clearinghouse will collect
margin on such trades, meaning it will
take extra collateral to help cushion itself
from losses. Initial margin, clipped at the
start of the trade, can be in the form of
liquid securities such as cash or government bonds. Variation margin, required
as the market price of the collateral fluctuates, can only be taken in cash.
“Variation margin is passed through
to the profitmaker of the [derivatives]
trade. That’s why it has to be cash,”
explains a product manager at a major
clearinghouse. The CCP will keep the
initial margin, either sending it to its own
custodial account if it is in the form of
high-quality securities, or investing it
through fully-collateralised overnight
repos if it comes in the form of cash.
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repo market participants, at a recent
capital markets event in London. “That
is probably going to create a situation where people are going to have to
exchange illiquid collateral.”
How to transform collateral
Banks that plan to provide collateral
transformation services say the first
line of defence for buy-side clients will
be collateral management, or sifting
through their assets to make sure they
are using them as efficiently as possible.
That may involve looking at a fund’s
entire book and figuring out what to
pledge and to whom.
However, if buy-side firms find that
they still lack enough eligible collateral
then they may choose to seek outside
help to convert some of their existing
inventory– such as equities or high-yield
bonds – into securities that can be used
“The push for more high-quality collateral
could even change the mechanics of the
wider repo market, where banks and buyside firms lend out trillions of dollars worth
of securities every day.”
Estimates for the amount of highquality collateral needed as part of
upcoming financial reform range from
$1,000bn to as much as $10,000bn after
including liquidity buffers, the war chests
of liquid assets that banks will be required
to hold under new Basel III rules.
But either way, it is expected to be a
significant amount.
Derivatives trades are “going to
have to be collateralised on a central
counterparty or on an exchange”, said
Oscar Huettner, global product manager
at BondLend, a technology platform for
to satisfy margin requirements, such as
cash or government bonds.
Custodian and dealer banks “transform” collateral through the vast securities lending or repo markets.
“We look into a client’s portfolio to
see if there’s anything available to meet
the margin requirement,” says Judson
Baker, product manager at custodian
bank Northern Trust. “After determining
that there may or may not be anything
available, that’s when we may partner
up with our securities lending desk to
provide a repo service for our client.”
Winter 2011 – the markit magazine
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Focus: Collateral transformation
Securities lending involves loaning
an asset into the market and taking in
cash, then potentially reinvesting that
money to generate a rate of return. In a
repo transaction, an asset may be sold
with an agreement to buy it back at a
later date.
Custodian banks say they are well
positioned to provide such a service,
since they routinely help optimise their
customers’ collateral and help facilitate
and settle trillions of dollars’ worth of
repo trades.
Contingent collateral liabilities
Risk management will also be key for
banks providing the service. They too will
have to monitor the daily market moves
and fluctuations in the collateral given to
them. They will have to determine if they
need to call for more collateral or return it.
But even with daily adjustments,
the proposed service is not
without controversy.
Some derivatives experts say the
service undermines the risk-mitigating
purpose of central clearing; creating
“The largest three or four exchanges are
looking very carefully at the quality of
collateral they can get and how far away
from government securities they are
prepared to go.”
But broker-dealers who clear derivatives trades on behalf of their clients
may also offer collateral transformation,
creating a streamlined process for buyside firms.
Crucial details of such services,
including legal protection for providers
and the fees they might charge for
transforming collateral, have yet to
be finalised.
In normal repo or securities transactions, a custodian bank will share
the cash that results from lending out
a bond. In the case of collateral transformation, however, that cash will be
needed by their clients, meaning fees
could be charged per transaction or as
a percentage of the notional value of
the trade.
Market participants are agreed,
however, that the move towards central
clearing will ultimately increase the cost
of using derivatives for buy-side firms.
“There are a number of different
variables that will make derivatives
trading more expensive,” notes BNY
Mellon’s Coleman. “That is the price we
pay as an industry for standardisation
and transparency.”
the markit magazine – Winter 2011
contingent liabilities for large banks
that could wreak havoc in times of
market volatility.
“The original reason behind clearing
mandates was to reduce systemic risk
but collateral transformation is just likely
to relocate it,” says Dr Craig Pirrong,
professor of finance at the Bauer College
of Business at the University of Houston.
“We haven’t really fixed the systemic risk
problem; we’ve just changed its address.”
Providers of the service don’t necessarily disagree that risk has been
moved, but say they will be able to
deal with potential problems through
careful management.
“What you hear people saying is the
CCP won’t accept your equities so why
should someone else? You’re not dealing
with the risk, you’re shifting it,” says
David Little, director of Calypso, which
offers collateral management services.
“The answer to that is the haircut,”
adds Little. “If people have priced these
haircuts correctly, then in the event of
default they should be able to make
themselves whole. Everybody who
needs collateral understands haircuts
and the need to get them right.”
However, the idea of margining and
haircuts – fundamental to the concept
of central clearing and collateral transformation services – are themselves a
concern for some.
“People are going to use balance
sheet in different ways to simply extend
credit and collateral transformation
is one of those ways,” says Pirrong.
“Because these services can be a
contingent liability, during periods of
stress, the banks are going to demand
higher haircuts to protect themselves.”
That, says Pirrong, can create and
accelerate feedback loops – with buyside firms liquidating their assets to meet
variation margin calls as market prices fall,
creating a further downward spiral.
Widening the collateral net
Buy-side firms might hope that central
counterparties widen their accepted
collateral, though the clearinghouses
will have to walk a fine line between flexibility and safety.
LCH.Clearnet, Europe’s biggest
fixed income clearinghouse, recently
expanded its portfolio of eligible margin
collateral to include gold and also
supranational bonds from KfW, the
German development bank. It’s thought
to be considering expanding that to
include investment-grade corporate
bonds and more agency debt.
“The largest three or four exchanges
are looking very carefully at the quality
of collateral they can get and how far
away from government securities they
are prepared to go,” says Northern
Trust’s Baker. “They have pressure to
compete in this space, so it will evolve.”
But even as the financial industry gears
up to deal with one consequence of new
financial regulation – the need for vast
swathes of high-quality collateral – there
may be new challenges on the horizon.
“There could be unintended consequences,” says Baker. “You have what
could be a pretty big impact on the general
repo market because you’re taking more
quality bonds out of circulation and
pledging them to exchanges. That’s an
aspect that will impact the market, though
we’re not sure how just yet.”