Demand for collateral is increasing and so is the cost. Collateral therefore has to be managed more effectively.
Demand for collateral is increasing and so is the cost. Collateral therefore has to be managed more effectively.
The use of collateral to secure cash loans, securities lending, repurchase agreements (repos) and other transactions has grown enormously in recent years as a result of market and regulatory change, and will continue to grow.
Since the global financial crisis, lenders and other market participants anxious to manage their credit risk exposures more carefully have asked for more, and higher quality, collateral from their counterparties. Furthermore, in many parts of the world, repos have gained in popularity as a source of financing, especially among dealers in bonds and derivatives, and this in turn has boosted demand for collateral.
Meanwhile, regulators, intent on reducing systemic risk, have introduced rules that are imposing greater collateral requirements on banks and other financial institutions. Under Basel III, for example, which has just come into effect in Europe through the Capital Requirements Directive IV and the Capital Requirements Regulation, banks must meet a liquidity coverage ratio; this means holding sufficient high-quality liquid assets, mainly in the form of government bonds, to withstand a 30-day stressed funding scenario.
The rules on the clearing of over-the-counter (OTC) derivatives transactions, which are currently being introduced in Europe, the US and several other jurisdictions, will also force sell- and buy-side firms to provide more collateral. In Europe, the European Market Infrastructure Regulation (EMIR), which is being phased in and should be fully in force by September, requires that all standardised OTC derivatives contracts be cleared through central counterparties (CCP), and with this central clearing requirement comes an obligation to post margin as security.
The European Securities and Markets Authority (ESMA) ultimately decides which contracts should be defined as ?standardised? and therefore subject to the clearing obligation, though national regulators will have a say in the matter too. Non-standardised contracts that are not cleared centrally (that is, they are cleared bilaterally between the two trading parties) are subject to even higher margins to reflect their greater risk.
As for OTC derivatives clearing in the US, Title VII of the Dodd-Frank Act now requires eligible products (ie, eligible swaps) to be cleared through regulated CCPs. Initial and variation margins are required for all centrally cleared swaps to help reduce risk in the market. Dodd-Frank uses the term ?swaps? as a synonym for ?OTC derivatives?, even though swaps are just one type—albeit the main type—of OTC derivative.
The Securities and Exchange Commission and the Commodity Futures Trading Commission, the two main relevant regulators, will determine which swaps are defined as ?eligible? and should be cleared centrally, but far fewer will escape this requirement than in Europe.
Collateral implications for OTC derivatives
Repos have gained in popularity as a source of financing, especially among dealers in bonds and derivatives, and this in turn has boosted demand for collateral. Mandatory central clearing for OTC derivatives transactions will therefore dramatically increase the collateral requirements for sell-side and buy-side firms. For many buy-side firms, it will be the first time they will have had to pledge collateral on their OTC positions because, under the old rules, collateral on bilateral OTCs was optional. Even if they already posted collateral on their OTCs, they are unlikely to be posting both variation and initial margins on a daily basis.
Sell-side firms, on the other hand, are used to these types of collateral arrangements. It is the buy-side firms, therefore, that will be hardest hit by these regulations as they struggle to cope operationally to manage and source the required collateral.
The three key implications, therefore, are as follows:
For centrally cleared transactions, firms will have to post an initial margin as collateral with the CCP. Posting of initial margin on OTCs is completely new for most buy-side firms. The precise margin requirements will be determined by the clearinghouse where the trade is cleared.
For centrally cleared transactions, firms will also have to post a daily variation margin with the CCP. Under the old regime for bilaterally cleared OTC derivatives, posting of variation margin as collateral was optional, not mandatory. Again, the precise margin requirements will be determined by the clearinghouse where the trade is cleared.
For non-centrally cleared transactions (ie those that are cleared bilaterally between the two parties to a transaction), there will be a different collateral process, and firms will have to post higher initial and variation margins than for centrally cleared transactions. The Basel Committee on Banking Supervision and the International Organization of Securities Commissions have developed detailed margin requirements for non-centrally cleared derivatives, which will be adopted by the EU, the US and other countries to ensure consistency around the world.
Needs must
The collateral raising and allocation process will therefore become much more important and complicated than hitherto. Whereas sell-side firms—investment banks, prime brokers and broker-dealers—will take it all in their stride, because collateral management is a core function for them, buy-side firms—asset managers, pension fund managers, sovereign wealth funds, insurance companies and end investors—will in most cases find it more of a challenge. Buy-side firms will need to look to sell-side firms and their global custodians for assistance.
Collateral management services for buy-side firms come in two main forms. The first is collateral optimisation. This is about finding and using collateral in the most effective way, based on a firm’s precise needs. The key factors include the sort of assets to use, in which country the collateral is to be provided, how quickly collateral is needed and, of course, the cost. The second service is collateral transformation. This is the process of transforming lower quality assets into higher quality assets needed as collateral to support a firm’s particular transaction and can be done through securities borrowing. The firm will borrow high-quality assets from a securities lender (such as a fund manager, insurance company or a custodian acting as an agent lender) and provide lower-quality assets (such as corporate bonds or equities as collateral). Securities borrowing and lending is only one way of transforming collateral; another option is repos, which can be used to generate cash in return for non-CCP-eligible securities.
Depositing collateral with a securities settlement system
An important aspect of EMIR is Article 47 (3). It states that collateral posted by a firm as a margin to a CCP should be deposited with the operator of a securities settlement system (SSS) if one is available. In such cases, the firm’s custodian will not be allowed to hold the collateral; it will be held by a party the firm did not select. This may mean having to accept terms, conditions and counterparty risks it would otherwise have not accepted.
Another drawback of depositing collateral with an SSS is that firms will find it harder to get real-time information on it than if it was held with their custodian. This will make the whole process of collateral mobilisation and optimisation more difficult. It is not clear why regulators believe that depositing assets with an SSS is preferable to leaving or depositing them with a custodian. Custodians have robust asset segregation models in place where assets are legally separated and held in a bankruptcy-safe model. In some cases, an SSS will have to use local custodians to hold assets anyway.
Striking the right balance
Organisations like the International Capital Market Association (ICMA) and the International Swaps and Derivatives Association are coordinating the industry’s approach to collateral management. They are developing strategy, education and information sharing, and lobbying legislators and regulators on matters of concern.
ICMA’s Collateral Initiatives Coordination Forum, set up in 2012, notes that “collateral demands will significantly outstrip supply, so it is essential that collateral be managed as a scarce resource”. It adds, “Given the competing demands that exist for the use of collateral assets, the management of collateral needs to encompass the deployment of optimisation techniques—to ensure that the available collateral is utilised as effectively and efficiently as possible.”
At HSBC, we believe that the introduction of central clearing for OTC derivatives transactions and the obligation to post margins—along with the obligation to post even higher margins for non-centrally cleared transactions—is a positive development. It will improve the management of counterparty credit risk and make the financial system sounder. Granted, it will increase demand for collateral, raise costs and reduce investor returns. But if the right balance can be struck, it will be worth it.
