The transformation of risk

The transformation of risk

Are market mechanisms able to meet the growing need for high-grade collateral?

In early April, the Financial Times began a feature article on collateral transformation as follows: "For centuries, scientists and philosophers attempted to turn cheap base metals into the precious gold and silver used as ancient coinage. Now, bankers are endeavouring to achieve a Wall Street equivalent."

The issue has come to the fore due to an anticipated shortfall in appropriate collateral to meet the expanded range of transactions requiring security. Collateralisation is seen as an obvious way to guard against counterparty default. While the demand for collateral is driven largely by regulation - in particular the promotion of central clearing for OTC derivatives - the belief that collateralisation is 'a good thing' is now widely held among lenders of all stripes, including central banks.

In a collateral management study released by SIX Securities in early May, 45% of participants said that collateral management is at risk of becoming a commodity. A further 30% already considered it a commodity. "I suspect that these results would change significantly if collateral shortages become a reality," comments Robert Almanas, Member of the Executive Committee, Six Securities Services. "Access to collateral, optimisation of collateral, and continued compliance to changing regulation will demand comprehensive servicing capabilities. It is hard to imagine that decisions in this context will be purely 'utility based'. Value-added criteria must be factored into the decision making process."

Josh Galper, managing principal, Finadium, an asset servicing and securities finance consultant, takes exception to the suggestion that the market's response to this growing demand lacks financial rigour. "There is no alchemy at all. In fact, the trade is exceedingly simple. There is no difference in a collateral upgrade in the securities lending market from any other securities lending transaction, nor in the repo market," he insists. "It's also important to point out that OTC derivatives are not the only source of this new demand for collateral: banks are also looking for high quality liquid assets. When you look at the concept of collateral shortages, there are multiple interlinking factors.

"OTC derivatives are not the only source of this new demand for collateral: banks are also looking for high quality liquid assets. When you look at the concept of collateral shortages, there are multiple interlinking factors."

Josh Galper
Finadium

"There is a general expectation in the marketplace that the demand for high quality collateral will outstrip immediately avail-able supply at some point in the next year. Differences exist, however, on why that gap will arise. Some focus on aggregate demand outstripping supply, others on the siloes that prevent potential collateral from being in the right place at the right time.

"There's no common agreement among analysts about whether there'll be a shortfall, how big a shortfall there might be or when it might hit," says David Little, head of securities finance at Calypso, a provider of collateral management and optimisation solutions. He attributes the differing assessments partly to the anticipated impact of netting: a small drop in netting efficiency could drive up the shortfall significantly.

"There's no common agreement among analysts about whether there'll be a shortfall, how big a shortfall there might be or when it might hit."

David Little
Calypso

One of the problems in making accurate predictions about market requirements is a lack of transparency around the unencumbered assets that participants have available to pledge. "The way securities are held today does not make collateral availability clearer," explains Peter Axilrod, managing director, new business development at the Depository Trust & Clearing Corporation (DTCC), the US post-trade utility. "They're held at the central bank in the case of US Treasuries or in the case of other securities at central securities depositories (CSDs), but are typically held in an omnibus account. We don't know how much of that is the custodian's collateral and how much belongs to customers. Only the custodians know that. You have to look through at least two tiers of information to figure that out."

In addition, changes in market practice will have a tangible impact on the frequency of collateral calls. "The market is clearly moving towards a daily revaluation of derivatives positions and therefore the collateral that's required to cover them," says Tony Freeman, executive director, industry relations, Omgeo, a post-trade processing solutions provider. "That will generate a huge number of margin calls."

"The market is clearly moving towards a daily revaluation of derivatives positions and therefore the collateral that’s required to cover them. That will generate a huge number of margin calls."

Tony Freeman
Omgeo

Regardless of how accurately the need for transformation services can be assessed, Axilrod accepts that demand for collateral is going to be much greater than it is today. "Under a market stress scenario, continual demand for new variation margin - which is essentially cash - is going to create significant pressure on the funding markets," he says. "Authorities are rightly concerned about where the collateral is going to come from during times of market stress."

One approach to gaining clarity, Axilrod suggests, is to require reporting on collateral and potential collateral. A second approach is to move collateral centrally. "All CSDs are under some pressure to work together to help maximise the ability of firms to bring collateral where it's needed around the world," notes Axilrod, who reflects the unease of many over the wider implications of central clearing of OTC derivatives. "Clearing requires any dip in value - temporary or otherwise - to be covered in cash that day. That creates a real question of how comfort- able authorities are going to be that there's enough funding capability in the system to make those calls. Ultimately, the holders of the great bulk of the collateral - which is currently fragmented - will need to find some way of working together to allow collateral to be brought to bear as needed but we're not there yet."

Collateral caution

The restrictive range of collateral accepted in the central clearing process for OTC derivatives exacerbates the challenge faced by the buy-side in adapting to the new market conditions. This is typically limited to high-quality government and agency bonds or cash for initial margin and, in most cases, simply cash for variation margin.

According to a joint paper1 by custodian bank BNY Mellon and Rule Financial, a financial sector consultancy, initial margin requirements can be substantial. Drawing on experiences in the interest rate swaps market, the paper notes that a typical initial margin obligation for a five-year vanilla interest rate swap might be equivalent to 1-3% of the notional value of the contract. Long-dated or complex contracts, on the other hand, may require substantially more collateral because of the greater potential future exposure; perhaps 10% of notional for a 30-year and 15% of notional for 50-year tenors.

Transformation in practice

There are effectively three ways for buy- side firms to exchange whatever assets they have for the ‘right’ collateral: source the collateral from within the internal silo where it presently sits; use the repo or securities lending markets to raise cash or eligible assets to post directly; or employ the services of a clearing broker or other intermediary to transform or upgrade the available collateral for an appropriate premium.

“We certainly believe that with the collateral shortfall, no matter what the number is, securities lending can play a role as well as repo. Lending is, after all, an established transformation mechanism on the broker side,” says Jeannine Lehman, securities lending business executive, EMEA, BNY Mellon. “That’s partly why we brought together the businesses within BNY Mellon into a division called Global Collateral Services.”

"We certainly believe that with the collateral shortfall, no matter what the number is, securities lending can play a role as well as repo."

Jeannine Lehman
BNY Mellon

 

Vincent Dessard, regulatory policy advisor at the European Fund and Asset Management Association acknowledges that the techniques of securities lending and repo have benefits in common: they provide relatively safe sources of income for investors and support the G20’s financial stability objectives through the use and facilitation of collateral. But, he suggests, “From an asset manager’s perspective, we believe that the two techniques should receive very different treatment.” He points out that repo settlement is made through delivery versus payment (DvP) and that repos are impossible to differentiate from normal trading activity in standard settlement cycles without voluntary reporting. Unlike securities lending, repos involve full transfer of title.

For Freeman, the main area of concern is the operational complexity of a collateral transformation process. “It isn’t simple; there are a lot of steps in the chain, a lot of things that can go wrong,” he says. “Say a margin call comes in at 17:00; you have to transform assets into something you can deliver to your clearing broker and they can deliver to the clearing house in the next few hours; operational complexity and the timing issue makes that something people are worried about.”

At times of market stress, when collateral demands may be expected to spike, the issue of cost is likely to be most keenly felt. “In the event of market stress, there is broad recognition that there will be a substantial rise in the need for collateral,” says Galper. “That may increase the cost of existing collateral transformation trades. If you and I had done a deal where I’m borrowing from you and paying you 50 basis points, you might in times of stress have offers from other people to pay you 100 base points. So the cost could rise substantially.”

Where is this leading? The least costly option to meet new collateral demands is likely to be to look internally for available assets across silos and geographies, though this will itself require investment in technology to accomplish.

Interestingly, SIX Securities Services’ research found that 56% of financial institutions have either replaced their collateral management system in the last 18 months or are in the process of doing so. Almanas identifies regulation and risk management as the primary drivers for this. “Legacy systems with suboptimal functionality such as batch cycles, end of day mark to market and limited asset classes expose firms to potential risks,” he says. “If systems cannot be adapted, then replacement is needed.”

Central depositories will also play a crucial role. Beyond that, market intermediaries seem confident that they will be able to meet the need for collateral transformation through commercial offerings. Until a clearer view of demand emerges, such confidence will be difficult to test.

1 ‘To Clear or not to Clear….Collateral is the question’, BNY Mellon Global Collateral Services, December 2012