Attempts to tackle systemic risk are justifiable, and reducing them makes perfect economic sense. However, the challenge is that the mitigation of risk is fuelled by exactly the same raw material; high-grade securities or cash collateral. The combined effect of the aforementioned regulations – such as EMIR, Basel III, etc – and changes in market dynamics could hasten potential collateral scarcity. While each legislative step on its own seems manageable, together they form a potentially insurmountable tsunami. The collateral scarcity could impact bank funding and lending for treasurers at smaller firms, while the large cash reserves available at bigger corporations will conversely be attractive, strengthening companies’ hand in any negotiations or indeed perhaps persuading some to go to market themselves.
During former periods of economic distress, collateral was easy to acquire as demand from the banks and market infrastructures was relatively low. If anything, there was an excess of collateral as regulatory requirements were less arduous, and there were fewer liquidity challenges. But, the financial environment of today cannot be compared to previous headwinds. Trust between financial institutions remains very fragile with some banks fighting to stay afloat, and unsecured lending and borrowing have been consigned to history. The sum of all of this is that the market faces a major problem – demand for high-grade securities collateral is expected to exceed supply.
Ready, Steady: Reform
Are buy-side firms and corporate investors ready for the post-regulatory environment on the world’s financial markets? Many experts would argue that overall readiness is slow. Strengthening markets and mitigating risks through the efficient use of securities collateral are noble principles, yet if handled incorrectly they could come at tremendous cost.
Changes to the derivatives market will be the second biggest category of IT spend in the global capital markets according to a recent report by SimCorp. Buy-side firms are expected to spend a total of EUR5 billion on IT developments globally. Most of this will be focused on complying with the Dodd-Frank Act in the US and EMIR in Europe for central clearing of derivative contracts. This spend focuses on getting firms up to speed with connectivity, pre-settlement requirements like matching and reconciliation, as well as common message formats and standards. It does not cover the requisite staff nor price-data feeds for the management of collateral.
Furthermore, central clearing puts buy-side firms in a precarious position, not only because they are unfamiliar with having to post margin for over-the-counter (OTC) trades, but also because this requirement will force them to re-engineer their decision-making process. To measure the effectiveness of their brokers and traders, buy-side firms will need to employ transaction cost analysis tools, which shed light on the underlying cost of executing a transaction. Managing costs will not be easy. For example, the margin obligations for a given trade may differ based on the chosen clearinghouse and/or clearing broker.
Picking the best-in-breed third-party provider of collateral management services will be key for the buy-side. Yes, many banks already have their own optimisation tools. However, these tend to work on a very basic level, often covering only local securities inventories. Do these banks have multiple and expansive ways of getting required margin to those CCPs that will in future process the hitherto OTC derivatives volumes.
Some industry estimates predict that certain CCPs will be invoking margin calls every 15 minutes out of a 21-hour business day. It is unlikely that many firms posting CCP margins have the in-house expertise and infrastructure to mobilise the right securities to the right place. Help is needed to mobilise useable securities from diverse securities pools fragmented around the world.
To achieve maximum collateral optimisation, the collateral management process needs to work across products, markets and depositories. This is the only way that a financial institution with a global presence can efficiently allocate collateral. And the only way this can truly work is if the market infrastructures, including intermediaries, interoperate to the maximum extent possible. Interoperability is needed between collateral management service providers, and between collateral takers, but especially between central securities depositories (CSDs).
One future change is essential: collateral criteria will need to be relaxed. Firms that previously did not need to post collateral, now find themselves under regulatory obligation to do so. For example, buy-side firms tend not to idly stockpile government bonds or cash. So, without some form of change, their business models are at risk.
Steps are already being taken to tackle many of the points discussed above. In recognition of the mounting pressure on financial firms, market infrastructures such as Euroclear Bank are tailoring its collateral management products to meet the evolving needs of the market. Firms need an infrastructure that eases access to the fragmented pools of high-grade collateral that are held in various silos worldwide.
Euroclear’s global ‘Collateral Highway’ was conceived to precisely relieve financial institutions of the burdens associated with sourcing, upgrading and mobilising collateral across geographic locations and time zones. Securities are sourced from multiple entry points, such as partner CSDs, agent banks and the group’s own CSDs, and then routed via the Collateral Highway to the right collateral taker at the right time, whether it is a central bank, CCP, repo or derivatives trade counterparty. Other clearing bodies are having to make similar moves.
Banks are facing two big challenges: First, many sovereign debt issues are being downgraded, hence the securities held by banks are also losing their quality status. Second, the move to a centrally cleared OTC derivatives market is driving collateral demand upwards, meaning that banks with previously adequate collateral reserves may no longer be equipped with enough of the right collateral to cover their daily activities. The potential bank counterparty risk implications for those treasurers assessing this might prove to be significant.
Collateral upgrade trades enable banks and other financial institutions that do not have the appropriate type of collateral in their portfolios to borrow high-grade securities from institutions that actually have stockpiles of such assets, using their lower grade securities as collateral. Lower grade sovereign debt, corporate bonds and equities are increasingly used to guarantee the loan. By doing so, these institutions are providing the market with crucial high-grade collateral, thereby improving overall market liquidity.
Will these steps be enough to navigate through this potential collateral super-storm? Only time will tell. But, the actions already taken are encouraging. The collaboration between previously fierce competitors demonstrates that the potential problem of collateral scarcity has been recognised by many as a dark cloud on the horizon that needs to be addressed. If and when regulators on both sides of the Atlantic reach agreement on a consistent and harmonised approach, the industry will be well placed to meet the collateral challenges ahead.
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