Treasurers who have been worrying that the scramble to meet tougher collateral requirements might price them out of the derivatives market in 2015 can breathe a sigh of relief. The prophesised collateral shortfall is not going to happen – at least not just yet.
Regulatory changes currently being implemented are expected to boost demand for high quality assets such as sovereign debt. Banks, of course, are now busy bolstering their liquidity ratios. Meanwhile, OTC derivatives will soon need to be collateralised and centrally cleared under new rules designed to make the $640 trillion derivatives market less risky.
But for all the anxiety and industry warnings, the amount of collateral available in the market continued to outstrip demand in 2014; a trend which is unlikely to change significantly in the short term. Precisely how much demand for collateral will increase once new clearing requirements for OTC derivatives come into full force is a matter of debate. The only thing that everyone agrees on is that the sums will be very vast indeed. By the estimates of the Bank for International Settlements (BIS), the amount of high quality collateral needed could be as much as $4 trillion, while others – notably the US Treasury – believe the figure is more likely to range between the $800 billion and $2 trillion mark.
Given the size of the various estimates being touted around, industry fears about a potential ‘collateral crunch’ are perhaps understandable. In early 2014, however, a joint-paper from the International Capital Markets Association (ICMA) and the European Repo Council (ERC) attempted to offer some reassurance. The study maintained that, overall, the supply of collateral would be sufficient to meet the growing demands expected in the wake of regulatory reform and changing market practices.
Figures cited in the report reveal that in the past six years alone the net stock of high quality assets eligible under derivatives regulations has increased by $11.3 trillion. The real question, then, is not whether there is enough collateral in the market, per se, but whether our fragmented market infrastructures can be transformed to allow for the mobilisation and delivery of the appropriate securities to where they are needed, when they are needed. It is this particular target that the securities industry has in its crosshairs right now.
The Collateral Highway
“I would agree with the notion that the challenge has been slightly overstated,” says Samit Desai, Principal Consultant at Capco. It is not a question of a shortage, he explains, it is the fact that some of the collateral that will be needed may be effectively silo-ed with investors who are unwilling or perhaps unable to lend. “There are significant pools of unlent fixed-income securities in the market. But how those are accessed is the crux of the issue,” says Desai.
Competitive pressures between central counterparties (CCPs) and market infrastructure improvements may also ease some of the strain, he adds: “Competition between CCPs may widen the eligibility criteria, which will make it easier to post different types of collateral. In addition, a reduction in clearing fragmentation and better portfolio optimisation should result in better netting benefits for firms, and therefore the total collateral obligation may reduce.”
Olivier de Schaetzen, Head of Product Solutions Global Markets at Europe’s largest international central securities depository (ICSD) – Euroclear – agrees that the so-called “collateral crunch” has yet to materialise, but whether or not the astronomical figures quoted by the likes of the BIS and US Treasury are exactly right is immaterial, he points out. The market is already seeing a significantly increased need for collateral, and consequently the industry needs to ensure the appropriate infrastructure is in place to mobilise collateral – often sitting idle – across borders in a quick and efficient way. Without such measures, there is a risk of some market participants being priced out of the derivatives market in the long run, he explains.
Chart 1: Future collateral requirements1 for OTC derivatives
Base case, $ trillion
1Excludes potential collateral re-use (re-hypothecation), and excludes netting across assets classes.
Source: Oliver Wyman analysis, BCBS/IOSCO QIS
Much work has already been done to this end in the past several years. Back in July 2012, Euroclear launched its global “Collateral Highway”. The global Collateral Highway, is an open, neutral infrastructure designed to help market participants move securities from wherever they are held in the world to serve as collateral for central bank liquidity, secured funding, and margins for CCPs and bilaterally cleared OTC derivative trades.
“It is a global infrastructure whereby liquidity providers – such as corporates, commercial banks and central banks – or risk mitigators – typically CCPs – can connect to receive securities as collateral from trading counterparties,” says de Schaetzen. “Since it is a truly global conduit we need to be able to move the right collateral seamlessly from any domestic markets into the collateral highway to where it is needed.”
To achieve that objective, the Collateral Highway uses multiple entry and exit points. The entry points are where collateral can be sourced through Euroclear’s central securities depositories and affiliated agent banks in every time zone. Once on the highway, the securities can then be transported to, for example, CCPs for initial margining.
The job is still ongoing, however. In autumn 2014, Euroclear and The Depository Trust and Clearing Corporation (DTCC), announced the finalisation of a joint venture to create a vast, cross-border pool of collateral. The decision to join forces under a newly created company, DTCC-Euroclear Global Collateral Limited, resulted from discussions that began in 2013 around what could be done to deliver strategic solutions that respond to regulatory requirements and could be used by all market participants. It was ultimately decided that working together and leveraging each other’s strengths, not to mention avoiding a duplication of efforts, made a lot of sense.
“We are seeing a real focus on infrastructure now to support all these regulatory changes and this joint-venture is very much involved in this space,” says Mark Jennis, Strategy and Business Development at DTCC and Executive Chairman of DTCC-Euroclear Global Collateral Limited. The joint venture will consist of two principle services. The first of these, called the Margin Transit Utility (MTU) will provide straight through processing of margin calls, from the point of agreeing a margin call through to settlement reporting and record keeping. Secondly, the Collateral Management Utility (CMU), will be piloted, focusing on the efficient mobilisation of collateral held at both depositories. “The CMU is about being able to efficiently identify, mobilise and allocate collateral,” says Jennis. “If a client held collateral in both the US and Europe, for example, it could be pledged either to a European clearing house or go in the other direction to a US clearing house.”
Through initiatives such as these, much progress has evidently been made to optimise market infrastructure in recent years. This is good news from the treasurer’s perspective, of course. Yet some may still be wondering how, precisely, they can get their hands on the high quality assets they now require to hedge, and just how costly that is going to be.
The truth is that collateral management is relatively unfamiliar territory for most non-financial corporates. It is something which only really began to become relevant in the corporate arena when, following the banking crisis, companies began to involve themselves in the tri-party repo market. It is an area which historically had principally been the domain of large banks, but could now be crucial in helping some corporates meeting their own collateral requirements.
“A lot of corporates awoke from a bad dream after September 2008, discovering that the risk they were taking on cash deposits was actually very significant,” says Euroclear’s de Schaetzen. As corporates began to accumulate liquidity in the years following the crisis, a shift in investment practices began to take place. Instead of continuing to invest their cash in unsecured term deposits taking on a single name exposure with the bank – at historically low rates, not to mention – some companies began to demand transactions be secured using reverse repos.
This technique enabled those companies to both mitigate the counterparty risk, and almost certainly secure a better return than they would have received through traditional deposits. “It was quite an important development for corporates,” says de Schaetzen. “The primary risk remains on the bank, but they now have collateral to cover the exposure and, in the event of a default of the bank, they can, as part of the agreement, sell collateral to recoup their cash investment.”
Bilateral repos can, of course, pose significant logistical challenges for treasuries in terms of the administration and risk management, particularly for those lacking experience in the market. Instead of handling all that themselves, many companies have chosen, instead, to go down the tri-party repo route, notes James Symington, Managing Principal at Capco. “The tri party agent will handle a lot of the reporting and risk management of the repos, taking some of that burden off the corporate.”
There is an added, regulatory benefit to the reverse repo, however. The collateral received typically comes in the form of high-quality bonds: the same securities, of course, demanded by CCPs for the purpose of covering derivative exposures. Corporates using the reverse repo may, therefore, find that the collateral acquired in return for their investments can create a pool of quality assets which can then be reused to cover derivatives exposures with the CCPs.
The advantages of recycling collateral in this way for the corporate is that it can substantially reduce funding liquidity requirements, says de Schaetzen. “If the cost of mobilising collateral is high, it could make the cost of hedging prohibitive,” says de Schaetzen. “By creating a buffer of collateral with the investment of excess liquidity in reverse repo, the treasurer doesn’t need to go into the market and borrow collateral, something which could be costly from their perspective.”
Every last drop
How, then, can smaller companies or firms with inadequate collateral get their hands on the high quality assets they need to satisfy their obligations in the new derivatives market? The concept of collateral transformation may provide at least part of the solution. Corporates may naturally be long on other types of securities – equities or corporate bonds, for example – that do not meet the standards stipulated by the CCPs, typically for AA+ rated government debt or above. Lower quality securities like these can be upgraded, however. “The process of collateral transformation is essentially taking ineligible collateral and transforming that to collateral that can be pledged to CCPs,” explains Symington.
In other words, it is a service that allows a customer – such as a corporate – that is holding a certain type of asset that they do not want or need, to swap it for the type of asset they do need, and in a way that is both efficient and cost effective. Fees and a slice of the security being exchanged are typically taken by the bank in exchange for the service, and the collateral is delivered in the form of a haircut, essentially a portion of the overall value clipped from the asset. This means that in the event of a default, the creditor should be able to make the value of the securities lent whole.
The fees around collateral transformation mean that hedging in the new emerging environment is likely to increase in cost somewhat, but that will still be considerably cheaper than buying such securities on the market.
And, as Capco’s Desai earlier alluded to, helping market participants make the most of the collateral pools that they have through collateral optimisation should result in the improved circulation of high quality collateral, thereby helping – along with initiatives such as the Collateral Highway – to relieve the demand pressures ahead.
The industry knows that addressing the expected growth in demand is going to be absolutely vital from a systemic perspective. After all, if a collateral crunch were to occur, it won’t just be the banks that suffer. Collateral has become such an intrinsic feature of the modern financial system that a scarcity of it would, in fact, put the continuing operation of the markets at risk. And this, it goes without saying, would have serious repercussions for the entire global economy. As the earlier referenced ICMA and ERC report notes, “collateral is becoming the new cash, underpinning the smooth functioning of funding and capital markets, and, in turn, providing the basis for economic growth”.