The cost of collateral transformation could mean fund managers will prefer collateral optimisation instead, finds Lynn Strongin Dodds.
In the not too distant past, collateral transformation was a key buzzword in the post-financial crisis derivatives world. Fast forward to today and the cost of converting lower-quality instruments into acceptable higher-grade assets via securities lending or repo will still be a viable option in order to meet new margin requirements – but fund managers are likely to go down the optimisation route first.
One of the main factors is the price tag. Put simply, collateral optimisation is less expensive than its transformation counterpart. The aim of optimisation is to make the best use of existing inventory across an entire firm. This typically involves either applying algorithms, compression/netting across assets, or simple prioritisation rules in order to reduce costs and improve liquidity.
Transformation, on the other hand, is more complicated and the costs are only set to increase as the slew of regulations impacting both derivatives and securities lending take hold. For example, as of January 1, 2015, securities lending agents will have to follow much more complex rules under Basel III, particularly in terms of how they provide collateral for indemnification.
In addition, the International Organisation of Securities Commissions (Iosco) and the Bank of International Settlements (BIS) have set out a much tougher regime for collateral requirements for over-the-counter (OTC) derivatives contracts not suitable for central clearing and conducted on a bilateral basis.
In the past, banks were more than happy to use their balance sheets to support clients’ OTC needs, but now they will be more constrained due to Basel III’s net stable funding requirements, leverage and liquidity coverage ratios.
The liquidity coverage ratios in particular will require institutions to hold a certain level of highly liquid assets to guard against short-term disruptions to liquidity. This means they will want to borrow high-quality securities for longer periods.
“It is too early to predict the outcome of the Iosco/BIS regulations but the sell side, especially the large broker dealers, have in the past lent their balance sheets to the buy side,” says Joern Tobias, head of product & strategy collateral services at State Street Global Services. “However, now that there will be much more scrutiny on their balance sheets, they may be pickier in terms of who they lend to.”
Expense is not the only reason collateral transformation has slipped down the agenda. Pressures on collateral stockpiles have eased, mainly because massive bank deleveraging has led to a dramatic drop in the quantity of collateral assets needed. Also, the supply of high-rated paper has grown significantly. While around $3 trillion (€2.4 trillion) of government securities have lost their safe-haven status since 2007, new issues of sovereign paper over the same period are well in excess of $15 trillion.
This is in marked contrast to two years ago when headlines were filled with estimates of shortages ranging widely – from the conservative figure of $500 billion to the dire prediction of $6 trillion. Many industry experts believe a more realistic figure is likely to emerge once the regulatory dust settles and will be the roughly $4 trillion forecast by BIS and other organisations. Breaking this down, this would include $1.4 trillion for OTC trades moving to central clearing, $1 trillion of non-central counterparty traded collateral and $1.8 trillion needed for banks to hold assets for the upcoming liquidity coverage ratios.
Another factor is that buy-side firms have been given more breathing space. For example, regulators have extended the mandatory clearing deadlines under the European Market Infrastructure Regulation (Emir). Instead of taking place this year, it will not become a reality before next December. In addition, European pension plans have an additional two-year grace period – and possibly a third year – which could push out their timeline until mid-2018 or 2019.
Although the buy side has an option from August 2015 to start the ball rolling, many are expected to take their time getting to grips with posting higher initial margins for all OTC transactions as well as multiple daily variation margin calls to central counterparties (CCPs). In the bilateral space, initial margin was rarely requested while custodians typically handled the variation margin – the amount of collateral required to cover changes in an instrument’s value – directly with the end-client.
The other reason to wait is to see how the Iosco/BIS existing proposals for initial margin requirements applied to non-cleared derivatives pan out. As it stands, the rules suggest an €8 billion threshold be applied to the regulations when they are phased in fully in 2019. The exemptions would cover those trading less than €8 billion notional in OTC derivatives at year-end, although pension funds, asset managers and lobby groups are joining forces calling for all pension funds to be exempt in full.
“Everyone was talking about the collateral crunch but it has not materialised yet as the regulation has not fully kicked in,” says Tobias. “There is enough collateral in the infrastructure to mobilise for the sell side, but this is a more difficult task for the buy side. Also, given the Iosco thresholds, it may just be the large funds that are impacted at the buy side. It is difficult to determine how much collateral transformation will be necessary.”
John Southgate, senior vice president of Northern Trust, adds: “The need for collateral transformation was fuelled by all the regulation coming through and the perceived shortfall that it would create. However, the increased pressures on collateral have filtered through much slower than expected because the deadlines were pushed back. Also, at the beginning of the year, fund managers focused their resources on the trade reporting requirements under Emir. Although some of the details of the regulations are still being worked out, the dates are fairly crystalised and now we are seeing our clients start to think about collateral management requirements within clearing, but they are also looking at optimising the assets they have across multiple silos within their enterprises.”
Stephen Bruel, vice president and head of derivatives product management at Brown Brothers Harriman, says: “We have not seen the level of collateral transformation that was anticipated, but that is likely because certain rules have not come into play yet. We have also seen some asset managers trying to resolve their own issues and sourcing collateral through internal means. They will try and optimise their existing assets to the point where they will not need transformation.”
Kelly Mathieson, global head of collateral management at JP Morgan, also believes that optimisation will be the first port of call. “Fund managers will be looking at the assets they have, where they are located, what can be used and rehypothecated and the value before transformation. The bulk of our clients have a sufficient amount of assets to meet collateral obligations, but they are not necessarily in a usable location at the right time, and they may need to transform them.”
Fergus Pery, a Europe, Middle East and Africa product head of OpenCollateral at Citi, expects demand to increase once the new regulations bed down. “Overall the levels of collateral will increase by several multiples and funds will have to get smarter as to how they use their eligible assets. However, the need will be on a fund-by-fund basis and their requirements will depend on their OTC activities and the underlying assets they hold.”
EXTRA ASSET CLASSES
The other issue is whether buy-side participants will step into the breach that may be left by some of their sell-side counterparts. “Potentially there is an opportunity for peer-to-peer lending,” says Southgate.
“The $64 million question is where will the extra collateral come from,” says Angela Osborne, co-head of the agency cash management business at Newedge. “Collateral shortages, should they emerge, could be mitigated by additional asset classes being eligible for central clearing. For example, there is talk about allowing ETFs [exchange-traded funds] and money market funds to become eligible at central counterparties. This could potentially help to alleviate potential squeezes in the repo market by widening the eligibility criteria.”
Osborne also expects that collateral transformation will be a feature in the future to meet initial and variation margins. “I think we will see an increase in the upgrade/downgrade trade that allows clients to transform ineligible collateral into eligible collateral or simply using repo to raise cash for variation margin. Buy-side firms will need to rely on multiple providers, and not just one firm to affect a robust collateral transformation solution to ensure adequate credit lines are in place to meet their margin requirements.”
©2015 funds europe