The real danger facing the market is a spike in costs due to the shrinking supply of high quality collateral, unexpected market events and growing demand on the back of regulatory pressures. Lynn Strongin Dodds explores the ramifications and various alternatives on offer in the market to help organisations avoid being caught in the collateral squeeze.
The scare mongering over the potential collateral squeeze had just started to abate when the US government spooked the market with its inability to reach an agreement on the debt ceiling. Yields spiked while clearinghouses slashed the value of US Treasuries as collateral. A temporary reprieve was found but the big question now is whether the scenario will repeats itself next February when politicians will try to hammer out a more permanent solution.
If recent history is anything to go by, there will be more wrangling although the jury is out as to whether it will last as long as the recent 16-day government shutdown in October. If negotiations are prolonged, then US Treasuries, which are the closest thing to cash, will once again be caught in the crossfire with bills at the shorter end of the curve losing their value. For example, in the run up to the October negotiations, the Hong Kong Exchange & Clearing raised the haircut to 3% from 1% on Treasuries with maturities of less than one year in margin requirements for index futures and options.
Although Treasuries have moved back to their favoured status, confidence has been shaken in this safe and most stable form of triple-rated collateral. There are viable alternatives but the danger is the pool of highly liquid triple-A rated sovereign debt is shrinking. This is especially the case in several Eurozone countries such as France, Italy, Spain and Austria which have seen their ratings being downgraded by agencies such as Standard & Poor’s. Cash is also a popular option but many buy-side firms baulk at holding too big a chunk due to the drag it can have on performance.
Clearinghouses have already responded by opening their collateral doors wider to accept equities, corporate bonds and gold although these assets can be more temperamental than their fixed income counterparts. Research shows that the average volatility of US bonds between April 1, 2009 and May 22, 2013 was around 170, compared with about 260 for US equities. The price of gold which ICE Clear and CME Groups accept also is unpredictable, having fluctuated between $1,687.22 and $1,205.53 per ounce since the start of this year.
At the moment, these issues are not imminent as there is enough high quality collateral swishing around the market. However, as the recent US experience shows, liquidity can drain out of the system overnight and the demand may outstrip supply in the future as the slew of regulations start to bite. This is not only the more onerous margin requirements under Dodd Frank and the European Market Infrastructure Regulation (EMIR) but also the liquidity coverage ratios embedded in Basel III. Putting an exact figure on the shortfall though has not been easy with soothsayers’ estimates veering wildly from a seemingly paltry $500 billion to a substantial $8 trillion.
Different numbers are also being crunched in terms of the cost of meeting these requirements. The International Organisation of Securities Commissions (IOSCO) in its latest report-‘Securities Markets Risk Outlook for 2013-2014’, did not produce a figure but warned that despite the financial system stabilising, the range of competing demands risked not only reducing the availability but could also have a negative impact on pricing. A recent study by SIX Securities Group – ‘Collateral Management: How Collateral Values Can Prevent The Next Crisis’ on the other hand, predicted that the expense of high grade collateral will increase by around 9% before 2015.
The study which canvassed 60 financial institutions from Europe, France and Germany also reflected the general confusion that has permeated the industry since the regulations have been introduced. Over half of the respondents polled anticipate a shortfall by 2015 although the majority do not expect the levels to reach the loftiest forecasts. About 22% believe it will be in the $10bn to $100bn range while 41% expect it to reach between $100 bn to $1 trillion.
“I think the industry has gone from panic to concern”, says Robert Almanas, managing director, international services, SIX Securities Services. “I do not think that people believe there is plenty of collateral around and they are also worried that the cost of eligible collateral will go up in the future. As a result, people are more open to new ways to use collateral more efficiently.”
This new opportunity – the ability to manage and optimise collateral in the most efficient way – has also increasingly become a revenue battleground with custodians as well as central clearinghouses (CCPs) honing and revamping their offerings. For example, in May, Euroclear, the Brussels-based settlement house and US based Depository Trust & Clearing Corporation (DTCC) joined forces to potentially create the world’s biggest pool of collateral. Under the agreement, DTCC customers will be able to access the Belgium’s collateral management system – the “collateral highway” – which holds more than €20trillion while Euroclear customers will be able to tap into DTCC similar system – the margin transit utility.
The success of the project, which addresses optimisation and settlement, also hinges on the participation of the major custodians, many of whom have launched their own services over the past two years. For instance, JPMorgan rolled out its collateral central platform which acts as a hub to allow clients to track and optimise their available collateral, including assets held at other banks and custodians while BNY Mellon has its global collateral services, which houses collateral management as well as finance, securities lending, liquidity management and derivatives services all under one roof. There is also Citi’s OpenCollateral solution – an open architecture, global collateral management product that can collateralise any obligation via any eligible collateral asset class, held at any custodian.
According to Almanas, the choice of a collateral management provider should depend on a broad range of factors including knowledge of local markets, real-time counterparty risk exposure, quality of the on-boarding process and multi-geography, currency and-asset class functionality.
The SIX Securities study showed that competition is intense with about a third of its respondents having added a new collateral management provider or replaced an incumbent in the last eighteen months, and another quarter (23%) are in the process of doing so. Cost was not the deciding factor. Around 53% chose an end-to-end collateral management provider to simplify their internal operations while only 18% believed lower expenses were the main advantage. The majority or 73% preferred using a tri-party collateral management system because it reduced risk, safely ring fenced assets and improved efficiency through the automation of processes.
“ For buy side firms it comes down to the nitty-gritty details of ensuring that they have sufficient collateral and the operational capability to support a much more complex environment that includes intraday margin calls,” says Fergus Pery, Citi’s EMEA head of OpenCollateral. “They want to be able to use the collateral they have as efficiently as possible. For the sell side this has already meant a huge investment. However, people at every stage of the collateral journey have had to raise their game to support the increased sophistication. Although it is hard to put a figure on it, it is clear in all cases that the amount of collateral will increase due to the OTC and banking regulations.”
Mark Higgins, managing director and EMEA head of business development for global collateral management at BNY Mellon echoes these sentiments. “One of the most important things to focus on is the aggregation of the data which is across multiple jurisdictions. The reality is that you can’t offer any of these services without making investments in technology and taking the time to develop effective ways to collect and collate information. That holds true for large investment banks or big or medium-sized asset managers because the collateral is becoming potentially scarce and certainly more expensive whether it’s cash or government securities.”
David Cassonnet, programme director at Quartet FS also agrees that success will hinge upon the ability of sell-side firms to be able to analyse large volumes of data in real-time. This not only includes changes in underlying market data but also asset prices and foreign exchange rates. Client positions may alter every few minutes or even seconds, so end-of-day data is no longer enough to keep pace with the market.
He adds, “Ultimately, collateral optimisation services should be scalable and flexible, able to adapt to future regulatory changes and provide real-time visibility across portfolios. Brokers that achieve this will become an attractive option for increasingly demanding buy-side clients and remain a step ahead of less agile competitors.”
Bob Holland, senior product manager, fixed income and derivatives, Linedata, adds, “There are many products on the marketplace and the challenge for the big guys is how they make their collateral management services extra sticky. The theory is that things change quickly but I think the more established players will be inventive and figure out how to retain and steer new clients to them.”
