Basel III presents new challenges to collateral trading activities and collateral management operations. In part II of a series, GCMS’ Saheed Awan explores the impact Basel III and central clearing of OTC derivatives will have on collateral trading activities and he calls for the restricted view of collateral management to be expanded to support efforts to achieve greater efficiency through improved and centralised processing.
Regulators and bank supervisors have become investment advisors!
Thus when the Basel Committee on Banking Supervision (BCBS) mandates through favourable capital treatment that specific collateral assets for accessing liquidity are better than others, such ‘investment advice’ motivates bank treasurers and their repo desks, custodians and asset owners to crowd into the government fixed-income borrowing and lending market.
Under the Basel III rules to be phased in by 2015, 60% of banks’ liquidity coverage ratio (LCR) must comprise cash or government debt in the Level 1 category with the remainder given over to Level 2 assets, which can lower rated sovereign bonds, covered bonds and high-quality corporate debt. The LCR has been designed to ensure that a bank maintain an adequate level of unencumbered, high-quality collateral that can be converted into cash to meet liquidity needs for a 30-day time horizon under an acute liquidity stress scenario. In addition to their use in the LCR, the need of such approved collateral is further incentivised with another favourite of the regulator – the central clearing counterparty (CCP). As we shall see later in this article such investment advice could result in recurring liquidity/collateral crunches.
Basel is driving 3 types of collateral trading
Currently it’s hard not to make serious money from lending of government bonds. The incentive provided by Basel III and the drive towards central clearing has led to three types of trades becoming particularly popular. The first is the collateral upgrade trade where the bank or broker-dealer delivers lower grade bonds as collateral against a borrow of sovereign bonds for use in their liquidity buffers and possibly for use as initial margin to CCPs. Second is the collateral transformation trade where lower grade bonds are repo-ed against cash for use as initial and variation margin to a CCP. The third type is the evergreen trade. Borrowers are increasingly seeking evergreen or long tenor loans to reduce or remove the maturity mismatch between borrowing government securities overnight by locking in loans or borrows on longer terms.
Collateral upgrade, collateral swaps and evergreen trades are basically bonds borrowed transactions.
The consequences of regulators becoming investment advisors
Inevitably there are going be a number of negative consequences from the tsunami of regulatory initiatives we are facing. Basel III in particular will present a major challenge to current collateral trading practices, which will require significantly increased capital allocation if not centrally cleared. In addition, the insurance industry, a major source of liquidity of both cash and government securities, will face its version of the Basel reforms in Solvency II, notably the increased risk weighting for exposure to large financial institution counterparties in bi-lateral transactions.
The easy answer it would seem would be to move securities lending and more of the repo market, including tri-party, into the CCP arena as is being done currently for OTC derivatives. However my experience of the high costs that the OTC derivatives industry is having to pay for central clearing and transferring the same model to securities lending and repo could mean one thing – that the buy-side (the lenders) keep their securities and cash out of the market. Then we are really about a big time collateral and liquidity crunch. It behooves the regulators to think through the unintended consequences of putting what is a currently not broken into the same mould as OTC derivatives. What was broken was the cash reinvestment programmes prevalent in the USA. Cash reinvestment is a different discipline and not widely used in securities lending programmes in Europe and Canada. However, the regulators and influential central banks like the Bank of England have their eyes on practices in the securities lending and repo market, which they equate with the shadow banking system. “Shadow” implies hidden, not transparent and not effectively monitored.
The best way to answer the regulators’ concerns would be exactly this – make securities lending, repo financing, and cash collateral re-use more transparent and get it out of the shadows. This would require the establishment of trade repositories for reporting purposes as is being done for OTC derivatives. That is the maximum the regulators should demand from the securities lending and repo industry. But if that is not enough for them and they still want to force all the OTC world into central clearing, then they should put their (the tax payers) money where their mouth is and provide backstop guarantees to CCPs. It is relevant here to quote Dr Craig Pirrong from his “Streetwise Professor” blog. Dr Pirrong is rightly called the “Streetwise Professor” because of his of acute and thoughtful, possibly cynical, observations as expressed below:
“This move by the Basel Committee is of a piece with legislative and regulatory efforts around the globe to drive derivatives from bilateral arrangements to cleared ones, under the belief that the former are inherently more systemically risky than the latter. But the danger is thinking about one risk being inherently greater than another. Indeed, it is this very kind of categorical thinking that has made previous Basel rules the incubators of crisis.
In earlier incarnations of Basel, government debt was considered very safe–so no risk weight. Mortgage debt was considered very safe–so a relatively small risk weight. Agency debt was considered inherently safe relative to corporate debt – so again, a small risk weight relative to the 100 percent applied to corporate debt. Ditto interbank exposures.
Thus, in an effort to make banks “safe”, the Basel rules incentivised banks to invest in government debt, mortgages and better yet, AAA mortgage CDOs, and agency debt, and to engage in massive interbank lending. And what happened? These supposedly categorically safe instruments were the sources of the ongoing systemic turmoil.
Now, the Gnomes of Basel are telling the world that cleared derivatives are categorically, inherently safer than bilateral derivatives. As a result, they are trying to structure the incentive system to drive derivatives onto CCPs.
Based on their track record: be afraid. Be very afraid.”
Is Dr Pirrong right to be so wary? The increase in initial margins for central clearing, and increased margining requirements for non-cleared derivatives, will increase funding and liquidity needs beyond the level that would be required without these mandates. And if we add to this the Basel III liquidity requirements, and the heightened potential for liquidity crunches in the new environment are clearly manifest.
Addressing the liquidity/collateral management challenge in Basel III
The BCBS prescribes that operationally collateral assets for liquidity access should be “under control of the functions charged with managing the liquidity risk of the bank.” One can interpret this to mean that most current collateral management operations will need upgrading from a generic back office collateral support function to a middle office trade support function sitting alongside the treasury or repo desk.
With regard to liquidity, banks are bound to face greater competition in respect of retail and corporate deposits. Cash from these sources will be much sought after as they are truly stable and long-term sources of liquidity. Banks with a strong retail and corporate franchises could therefore be clear winners as net providers of liquidity. However even banks with currently a substantial franchise of such customers will need to wake up to the increased competition they will face from rivals with innovative products coupled with enhanced customer services. One of the best such products will be the extension of repo as a secure wholesale money market investment into the retail and corporate sectors. It is surprising that at a time when banks are suffering recurring liquidity crises that they have not sought to attract higher levels of deposits beyond that guaranteed by governments deposit insurance schemes. I look forward to the day when a bank gives me or a corporate treasurer the ability to move cash on-line into a choice of collateralised money market products offering varying tenors with a selection of collateral baskets – from AAA down to just above investment grade. The bank or the broker-dealer gets to refinance all or most of their inventory from a stable pool of investors who in turn can achieve higher returns than currently available, plus the saving institution’s credit risk backed up by collateral. Offering such a product will require re-engineering and re-tooling of collateral management operations – from serving only the wholesale side of their banks to serving substantial amounts of pooled retail and corporate cash.
A product like retail repo goes to the heart of liquidity crises and meets a number of core principals of Basel III. Foremost is reducing banks’ dependence on wholesale markets for their funding needs. The BCBS has recommended increased risk weightings on positions against other financial counterparts. The BCBS rightly recognises that the correlation risk in these positions is significantly high and thus are making serious efforts to reduce interconnectedness and the likelihood of contagion during a crisis. Hence retail and non-bank corporate sources of liquidity become very attractive in terms of regulatory capital treatment. Such sources of cash also meet another key Basel III requirement. This is the Net Stale Funding Ratio (NSFR). The NSFR is a long-term ratio that measures how much stable funding a firm has to endure a year-long liquidity crisis. Apart from banks issuing their own long term debt the best source of such stable funding is the retail and corporate sector. So far only one attempt known to me has been made to tap such sources through a repo type structure. This is the Ulf Bacher and Angela Osborne agency cash management service at Newedge.
Is this “collateral management”?
To better meet the requirements of new regulation such as Basel III, financial institutions will no doubt have to develop more sophisticated collateral management capabilities. However, before embarking on such a revamp, some market participants need to better understand that collateral management is more than just margin management.
Bonds borrowed trades and collateral upgrades, as mentioned previously, are an integral part of collateral management processes but the focus for many market participants is mostly on managing margin of OTC derivatives trades. Market participants (both operational professionals and software vendors) need to understand that collateral management is more than just moving cash around.
Also, the high use of cash as collateral to meet margin calls is highly problematic.
Cash is the firm’s liquidity and life-blood and the last thing one would expect a collateral management professional to be giving away is their firm’s liquidity to meet a margin call if there are other cheaper alternatives from the inventory. The restricted use of collateral management adopted by those relying on cash, as opposed to the full spectrum of assets like bonds borrowed, leads to poor or no servicing of areas that require “real” collateral management support – areas like repo and securities lending. Inevitably silos are created where collateral for securities financing trades is managed and monitored separately in operations (generally with spreadsheets) from OTC derivative margin calls. Silo processing of collateral creates other problems.
More than Enterprise-wide Collateral Management
Consultants and system vendors have written numerous articles on the need for deploying firm-wide or enterprise-wide collateral management systems. In my experience the answer lies not just with getting the right system to do this but putting in place an operating model that includes:
∞ • upgrading the collateral management function from an operations back office function to a middle office right next to collateral trading desks;
∞ • staffing this with enhanced securities settlement and specially bond market knowledge and;
∞ • integrating counterpart’s eligible collateral profile to up-to-date securities reference data, securities pricing data and corporate action data with the firm’s entire securities and collateral inventory.
With these key elements in place, any kind of exposure – a margin call to meet an OTC derivative exposure, posting initial and variation margin to a CCP, pledging appropriate and sufficient bonds for a repo or securities borrow transaction – can be met in the most optimum and timely manner.
Automation and a New Era for Collateral Management
The ultimate of course is auto-collateralisation where exposures are captured from upstream systems in real-time, and eligible and sufficient collateral (not cash as the first and easy preference) is automatically selected from the inventory (hence the need for good quality securities reference data), with settlement instructions being generated automatically to cover the new exposure. Such an operating model needs to run in real-time or near real-time as the collateral inventory and exposures will be constantly changing through the day and therefore substitutions of currently pledged collateral can be undertaken with changes in the inventory.
Such an operating model and level of automation is possible. It is interesting to note that the feedback I receive from the majority of collateral management professionals, both system vendors and users, is one of disbelief when I present such an operating model. They think that such automation is not possible or nobody will want it! It is possible and is in use currently. And it will be this ultimate level of automation with total straight through processing that will distinguish the winners in an era where efficient and optimal collateral/margin management will be key. That era is now – with or without any regulatory incentives.
