The gathering storm
Recent months have seen rising tensions over the seemingly insurmountable demands for collateral prompted by tough new financial regulation. With US Treasury estimates ranging as high as to $11.2 trillion in stressed market conditions, some observers are deeply concerned that the industry could be in danger of sliding into a black hole of collateral shortages and further crisis.
According to research house Celent, the full cost to fully upgrade the financial industry’s infrastructure to make efficient use of collateral could reach $53 billion – and even then, asset managers can expect to swallow a 20% increase in the cost of collateralisation as high-quality, in-demand assets begin to dry up. Added to that is an expected by dramatic rise in margin calls – up to seven times, according to some estimates.
The cause of all this additional cost pressure is of course regulation, much of which attempts to strengthen the resilience of banks and correct the systemic weaknesses exposed during the financial crisis. Basel III requires banks to deleverage and set aside more capital; Dodd-Frank in the US and EMIR in Europe require the bulk of OTC derivatives to be standardised, centrally cleared and reported and where possible traded on exchange-style platforms.
Six Securities Services has warned that changes prompted by the new regulatory environment may result in commoditisation of collateral management – with potentially deleterious effects for market participants as different providers descend into undifferentiated price competition, reducing the quality of risk mitigation that collateral management then provides.
“Collateral management is far more than just providing a view of, and netting, multiple streams of collateral across silos,” said Robert Almanas, head of securities finance solutions, SIX Securities Services. “Collateral management controls counterparty risk exposure more efficiently and ensures that market and operational risks are mitigated. Tri-party collateral management systems completely ring-fence a financial institution’s assets, protecting them from co-mingling and, in the event of a default, allow segregated assets to be easily identified and returned to their owners.”
In March, Almanas warned that a decision by the Basel Committee on Banking Supervision to include assets rated as low as BBB-minus bonds in the definition of high-quality liquid collateral risked sowing the seeds of the next financial crisis. Calling into question the concept of a collateral shortfall, Almanas asked whether it is the case that there is not enough collateral, or whether it is just that the industry needed to use collateral more efficiently. Breaking down siloes and resolving inefficient use of collateral should be a priority, he added.
So what can be done about it?
The new rules have already prompted several organisations to develop their own solutions, designed to maximise the efficiency of collateral. In April, Standard Chartered enlisted Clearstream and Euroclear to a new scheme designed to help investors margin their exposures from a single, larger collateral pool. Meanwhile, Citi has recently introduced segregated collateral custody accounts to help improve the efficiency of collateral and formed its own deals with Clearstream and Euroclear. In addition, in January the central securities depositories of Germany, Spain, Brazil, South Africa and Australia formed a Liquidity Alliance that aims to tackle the global collateral shortfall.
Yet according to Saheed Awan, global head of collateral management and securities finance at Euroclear, the doom-laden figures pointing to a collateral apocalypse are unhelpful, and may be misleading. He cites estimates by the IMF and the Bank for International Settlements that suggest the true figure is likely to total between $4-6 trillion to cover the cost of Basel III, the clearing of OTC derivatives and the increased margin required for the remaining non-cleared contracts.
“There is a lot of scaremongering going on,” he said. “The truth is that there is enough collateral out there to meet the needs of CCPs and banks – it’s just that a lot of it is currently locked away in silos. The real problem is not so much the amount of collateral – it’s the five to sevenfold increase in the frequency of margin calls, which means that people need to mobilise their collateral much more quickly. We are working with agent banks and CSDs like the DTCC to unblock that collateral and move it where it’s needed.”
According to the Celent research, firms cited a need to focus on collateral efficiency (67%) and operational efficiency (62%), with an emphasis on improving efficiency at the core around margining processes. Despite the ongoing rollout of the regulation by stages in Europe and the US, many firms are still not ready; some 48% of respondents have not completed operational preparations to cope with margin call increases or new regulation, while of those that have, firms cited margin call inefficiencies (43%) and limitations of existing systems (38%) as the most significant remaining challenges. The number one competitive advantage will be the degree of automation and efficiency in how firms manage collateral, concludes the document.
“The differentiator between winners and losers will entail frontline strategy decisions that are enabled by timely collateral inventory information and margining operations, as opposed to firms that may face limitations on what/how/where they trade”, said Cubillas Ding, research director at Celent and author of the report.
Euroclear’s deal with the DTCC initially consists of a margin transfer utility, which is designed to link up the entire chain from the buy-side to the payment systems to the clearing members and the CCPs. The firms aim to use the industry-wide utility structure to achieve high levels of STP, which can then be used to handle the increased level of margin calls. The project is due to go live in Q1 2014.
Casting the net
However, the collateral crunch cannot be entirely written off. Awan at Euroclear acknowledges that there is a second part to the dilemma. The velocity of collateral will probably reduce because of the regulations, he says – meaning that where previously market participants have been able to re-use collateral further down the settlement chain, under the new regulations collateral will be held in place, in segregated accounts, with no possibility of re-use.
“When CCPs receive collateral, it’s just held there as initial margin,” he said. “On top of that, the buy-side is insisting that their initial margin should be segregated away from both their clearing broker and also the clearing house, in a third-party trustee structure. The AFMD rules, which take effect in July, state that collateral placed by hedge funds can no longer be held by the prime broker. It has to be segregated away into a depository. All this means that more collateral has to be unblocked to fill the gap.”
Euroclear is currently targeting the major global central banks, including the US Federal Reserve, the Bank of England and the European Central Bank, in a bid to access the collateral they hold. According to Awan, the central banks have been buying huge quantities of high-grade assets, including government bonds, as part of their quantitative easing programmes. Euroclear offers to lend out those high-quality assets as collateral, theoretically earning a return for the central bank while simultaneously easing the global shortage of high-grade collateral. He suggests that hedge funds and pension funds also stand to make significant returns next year by participating in lending programmes when high-quality collateral coverage is in high demand.
The other main challenge is that there are different collateral frameworks in the market, he said. The ECB has a very wide list of eligible collateral, include triple B minus bonds. The central banks are fairly loose in their criteria for acceptable collateral, since they are trying to provide more liquidity; at the same time, the regulators are trying to drive more business towards central clearing counterparts. But since the CCPs are very strict on the collateral they will accept, and impose tough haircuts even on the highest quality securities, the collateral-related cost to use CCPs remains relatively high. That means that it would be wise to consider other sources of collateral, he suggests.
“Most people define collateral in terms of the rating of the collateral,” said Awan. “But the market needs to look at collateral in terms of liquidity. You only need collateral when there’s a bankruptcy – and if there is a bankruptcy, you need to sell that collateral very quickly. What sells the fastest? Liquid assets. Yet some of the most liquid assets in the world – blue chip, highly capitalised equities, like Apple stock or GSK – are rejected by most institutions. That doesn’t make sense to me. Would you not rather take that equity, rather than some of the sovereign debt we have currently in the marketplace? If equities were accepted more widely, there would be no talk of a collateral crisis.”
At present, equities have a relatively high-risk weighting on bank balance sheets, making them unattractive versus bonds, while CCPs would need regulatory approval to accept new kinds of collateral. However, according to Awan, BIS is already looking into encouraging regulators to change that state of affairs.
The technical standards for EMIR came into force on 22 March, after which CCPs will have six months to apply for registration. Once that takes place, a 90-day period will follow in which market participants are given notice that they must clear all products covered by the new rules. It is estimated that market participants will be bound by mandatory clearing obligations by Q1 next year.
