Limiting collateral damage
The regulatory focus on moving to exchange trading and higher capital charges for over the counter (OTC) instruments is increasing the demands for collateral worldwide. It is a demand that is also expected to become greater. It has been forecast that $2 trillion of new collateral, globally, would be required to meet the needs of cleared derivatives in the central counterparties (CCPs). However, in the US, where mandatory clearing has already started for all market participants, there has been some mobilisation of collateral but not to the extent that was initially expected, writes Frances Faulds.
Furthermore, Saheed Awan, global head of collateral services and securities financing products at Euroclear, says the forecasts of a collateral shortage that have been predicted during the past three years have not materialised. Numerous studies have shown that there is no shortage of collateral, he says; the issue is, and continues to be, that financial institutions operate in such a way that collateral is siloed not only internally but also geographically.
For this reason, he says, the focus for infrastructure providers such as Euroclear has been on what can be done to free-up collateral, whether it is in domestic markets with different agent banks or depositories, and get it to the right places. “Our aim is to mobilise it, deliver it and allocate it in the most optimal way to the central banks, clearing houses or liquidity providers,” he says.
This is why Euroclear has been partnering with agent banks such as BNP Paribas, Citi and Standard Chartered to offer automated collateral sourcing, global pooling and optimised allocation for both financing and margin delivery. It has now linked six markets in Europe and in November 2014 it goes live in Asia with Standard Chartered for asset mobilisation in the Hong Kong and Singapore markets. Using the same technology, participants in Euroclear UK and Ireland will be able to automatically mobilise assets in the Crest system for financing in Euroclear’s global market infrastructure, the Collateral Highway, from March 2015 onwards.
Awan says: “We are linking up either directly with the CSD or with agent banks and looking at seamlessly mobilising both bonds and equities so the repo traders or the securities lending desks needing collateral do not have to worry about how this will be delivered and settled. They don’t even have to know where the assets are; they simply trade and Euroclear will do the rest.” Furthermore, Euroclear continues work on partnering with the US-based Depository Trust and Clearing Corporation, the largest asset market in the world, on a collateral processing and trans-Atlantic collateral mobility and optimisation project earmarked for implementation late 2015.
In Europe, the European Securities and Markets Authority (ESMA) has finally released its technical guidelines on mandatory clearing. Clearing brokers will need mandatory clearing in place by June 2015 if the legislation is approved by the European Parliament this year. All other financial institutions, the fastest growing part of the derivatives market, would have a further 18 months. “So, the urgency for collateral optimisation and the mobilisation of high quality assets is unlikely to really increase until the end of 2016. This has taken the heat out of the concern of whether there is enough collateral,” Awan adds.
But even without the imminent mandatory clearing requirements, collateral is the lifeblood of the financial markets and institutions that did not previously have to put up collateral are now being asked to. Awan says: “The problem for asset managers is that they are not in the business of collateral management, they don’t have the technology or the expertise and this exercise has been painful for them. A lot of them are not ready and therefore they need the later deadlines to prepare for mandatory clearing.”
The regulatory focus on exchange-driven business also means that the management of collateral needs to be more effective. Robert Scott, head of custody and collateral solutions at Commerzbank, agrees that studies are pointing to the fact that there is sufficient collateral around but that it is displaced and simply in the wrong place at the wrong time. He says: “Historically, financial institutions have built many relationships with banks and service providers, both centrally and bilaterally, so that their collateral is dispersed worldwide to support trading businesses. With regulations forcing more business to the exchanges, it is also forcing the banks and the market infrastructures to look at how they can mobilise collateral in a more effective way.”
As more business moves to exchanges and away from bilateral trading, Scott says there will be a greater need for the free movement of high quality collateral to support trading activity across the time zones, which at the moment market infrastructures do not support. “There is a lot of inefficiency here and clients are faced with the risk inherent in moving collateral or using the service providers to avoid moving it.”
Commerbank’s newly-created market services division is finding creative ways to enable clients to more effectively pool all of their post-trade collateral and help them to solve the problem of moving collateral in different time zones while adhering to different market cut-offs and eligibility criteria. “We try to look at this for a client holistically, across all of their obligations and activities globally and optimise this in the most effective way, which minimises the physical movement of collateral. This has forced clients and banks to look more closely at how they use collateral and the cost savings that come with better management.”
The margin offsets now being made available because OTC and exchange-listed products are being brought closer together are significantly improving the potential for collateral efficiencies as well as improving the cost benefits. Commerzbank was one of the first European clearing brokers to use the service recently launched by Eurex Clearing, enabling OTC clearing to be offset against listed derivatives. Scott says: “Eurex suggests that you can get up to 70 per cent relief in collateral requirements by pooling collateral with the clearing house and we would agree with that. The need for increased collateral will be critical going forward so you can no longer afford to have more than 20 different relationships with service providers because this means your use of collateral is inefficient and you are not getting the benefits of offsetting.”
The incoming regulations have prompted global custodian BNP Paribas, with more than $9 trillion assets under custody, to develop Collateral Access to help clients become fully compliant with the new requirements in a short timeframe and with minimal investment. Collateral Access comprises three pillars, each one encompassing three modules to actively manage counterparty risk mitigation, optimise collateral allocation and both protect and deliver margins direct to the CCP.
Philippe Ruault, head of product for clearing and settlement at BNP Paribas Securities Services, says: “This integrated solution combines the tendency of asset managers to outsource collateral processing by managing the reconciliation and evaluation of collateral as well as monitoring the movement of collateral. We have a number of solutions to automate and manage the processing of collateral, such as Margin Protect, where we act as a safe keeper of the margin collateral for sell-side and buy-side firms to margin all their transactions. An optimiser then looks at the available assets and at the rules and conditions that have been put in place by the asset managers and finds the best match.”
This ensures both the safekeeping and segregation of collateral, which is now a requirement under the European Market Infrastructure Regulation. Ruault says the protection of the collateral portfolio is a key concern of clients, while Collateral Connect provides connectivity to market infrastructures, including the CCPs and prime brokers, to reduce liquidity friction between counterparties.
Anne-France Demarolle, head of liquidity management, at Societe Generale Securities Services (SGSS) says the global regulatory reform and differing rules across jurisdictions, which result in an increasing fragmentation of markets lead to a more complex set of relationships for market participants. Securities services providers have a role to play by providing both insights into the new requirements as well as solutions, she says.
“The challenge is not only about having a holistic view of customers’ collateral needs but of their available collateral resources,” she says. “An additional challenge is not only needing to know what collateral is required for each specific need, be it a cleared OTC or bilateral transaction, but also the collateral size that will be eligible. For this, an inventory of all available collateral resources is needed and it is only then that assets or cash allocations can be optimised and new resources unlocked through collateral transformation.”
This comes with a cost, the cost of consolidating all the information in one place but, she adds, the organisational and technological changes that market participants must put in place to remove silos is needed more than ever. Says Demarolle: “Collateral management is becoming a front-office activity. All trading activity, whether it is OTC bilaterally-traded, listed products or securities lending, today is linked by collateral. For this reason collateral transformation and collateral optimisation are obviously part of the equation when firms are looking at reducing their costs.”
Due to the increasing complexity of customer requirements, SGSS has taken a modular approach to the services it provides, enabling customers to choose a full service or simply the building blocks they need. By offering modules from clearing through to collateral transformation to reporting Demarolle believes this addresses the biggest concerns of complying with the incoming regulations while trying to contain costs. “Furthermore, as well as getting access to value-added services, clients can transform fixed costs to variable costs when they are outsourcing the service,” she adds.
Three main collateral management models are emerging, says Jerry Friedhoff, managing director, Securities Finance and Collateral Management at Broadridge. The spectrum ranges from the traditional siloed approach by asset class or region, to the hybrid model, to the fully integrated model across all asset classes and regions, globally. “Most of our clients are currently using a hybrid model. They are trying to streamline their derivatives collateral management into a global service model but they will also have independent fixed income, repo or regional centres.
“Some have decided to invest heavily in building a fully integrated collateral management solution and overlaid this with a collateral optimisation capability to leverage their collateral across different regions, pool, arbitrage and deal with the transformation of collateral. They have achieved significant economies and the return on investment far outweighs the cost of achieving it.”