Worries for collateral scarcity reduced

seasaw2Investors involved in complex transactions are unlikely to suffer from a shortfall of collateral, academics said this week in a move that could end several years of speculation that collateral would become scarcer.

A London School of Economics and Political Science (LSE) study has found that the supply of collateral, in principle, will be sufficient to meet growing demands expected as a result of regulatory reform and changing market practices.

Collateral, which offers protection against the collapse of a counterparty, is used in a number of investment fund transactions, including clearing and over-the-counter (OTC) derivatives contracts.

But the academics warned that despite collateral availability, access to collateral could be a challenge because the market is fragmented, affecting the speed of collateral delivery.

For example, said the authors, a bank clearing trades across four markets could experience a near 10-fold increase in margin movements if these were cleared through four separate CCPs. Dealing with different CCPs rather than one loses the benefits of netting. The scale of the problem is sufficient to threaten markets with a systemic event.

The report’s authors, Ronald Anderson and Karin Jõeveer, called on market participants and infrastructure providers to work together on technical solutions and processes that streamline access to collateral worldwide.

“For several years, there has been much debate on a collateral shortage. Our research has found that the challenge does not lie in the global supply of collateral in aggregate, but rather in the accessibility of collateral across markets and participants,” said Professor Anderson. “The search for new methods to alleviate bottlenecks and seamlessly allocate collateral is the next challenge for infrastructure providers and participants. Collaboration between participants and infrastructure providers will be crucial to ensuring an efficient process.”

Moves to tighten collateral rules are in line with the G20’s aims for improved market stability following the 2007/8 financial crisis. The G20 enacted a reform of OTC derivatives, which in Europe is implemented through the European Market Infrastructure Regulation, with a requirement for OTC derivatives to be cleared centrally.

After the crisis, collateral users sought safety in higher quality collateral – such as certain sovereign bonds and investment grade bonds – and this practice, which continues, led to the concerns over scarcity.

The authors stated that problems relating to collateral access can be overcome by improved information systems and collateral transformation.

The Economic of Collateral report was backed by The Depository Trust & Clearing Corporation.

©2014 funds europe