A host of market drivers are pushing and pulling the collateral market in several directions at once, and the best way forward remains unclear. Industry experts attempt to unpick the challenges
Panel participants
Bimal Kadikar
CEO and founder
Transcend Street
Roberto Verrillo
Head of strategy and markets
Elixium
Michel Frei
Head of collateral management
Zürcher Kantonalbank
Martin Seagroatt
Marketing director for securities finance and
collateral management
Broadridge
Emily Kalbag
Product consultant for collateral management
Lombard Risk
Olivier Grimonpont
Head of collateral management and
securities lending
Euroclear
How will the recent rate hikes affect demand for non-cash collateral under the new regulatory framework?
Roberto Verrillo: Rate hikes, and movement in interest rate curves, for some will involve having to pass more margin, increasingly in the form of cash. With the well-documented issues around collateral to cash transformation and capacity/cost, this could prove to be expensive should the markets price in steeper curves.
Martin Seagroatt: Rate rises can change the dynamics for some interest rates swaps, necessitating transfers of margin and lead to a requirement for some market participants to source higher quantities of collateral. In addition, interest rate rises can also change the opportunity costs of holding different asset classes.
We will also see more securities coming back into the market through tapering, as central banks remove cash from the system, meaning a larger supply of securities available as collateral.
Olivier Grimonpont: It is fair to say that the evolution of rates has always been one of the factors playing a role in the cash versus non-cash collateral decision, however, the weight of the regulatory requirements (for example, segregation requirements) and of the cost of capital has increased and will continue to support the demand for non-cash collateral.
What can be done to install new frameworks to release new sources of collateral to address potential shortfalls?
Bimal Kadikar: Our feeling is that the first step is acknowledgement by key stakeholders that collateral is a valuable, common asset throughout the organisation. Coordinated use of this collateral will be an ongoing strategic imperative for all successful financial institutions. Because collateral is usually isolated across business silos, disparate margin and operations centers and treasury areas, there is a tremendous amount of inefficiency when it comes to optimising allocations, particular when viewed at the enterprise level.
Therefore, optimisation can be a tremendously powerful tool for increasing available sources of collateral and matching them with targeted uses. Unfortunately, there is no silver bullet to implementing optimal collateral efficiency. Every organisation will have its own needs and strategies. But at a fundamental level they will have to understand all the constraints on their collateral and be able to analyse a comprehensive collateral dataset of positions and balances. Once this is in place, operating decisions can be executed with a focus on straight-through processing. If done right, the firm should benefit through an enhanced liquidity, risk and cost profile across the enterprise.
Grimonpont: The Euroclear Collateral Highway has been developed around that problem, that being, the ability to mobilise assets, wherever they are held to wherever they are needed to meet increasing collateral obligations. It is for that purpose that in cooperation with agents and central securities depositories head of our collateral management and securities lending CSDs, we have launched inventory management services to allow a smoother mobilisation of securities whether held within or outside Euroclear. And through our joint venture with DTCC, we are allowing smooth mobilisation of US assets onto the Highway.
In addition to accessing various pools of collateral where they are initially held, it has become important to support non-banking institutions in lending their high-quality liquid assets (HQLA) against less liquid collateral, providing them with a robust operational and legal environment to conduct these transactions. Those include triparty collateral management services as well as linking to new all-to-all trading platforms to help those firms to, safely and efficiently, generate additional revenues while enabling their HQLA assets to be used as collateral to cover potential shortfalls.
Verrillo: Elixium is designed to specifically address the impact of regulation, balance sheet pressures, and deteriorating levels of liquidity in the repo market by providing participants with collateralised liquidity on a fair, transparent, low-cost and equitable basis. It was created in response to the market requirement for an all-to-all marketplace in collateral and secured deposits.
Michel Frei: One of the most efficient ways to source collateral is the repo market. The problem is that most of the big platforms don’t give you full access on the collateral received. So, even, there is enough liquidity to source collateral on those platforms, you end up not being able to really use the collateral where you need it. New frameworks should ease interoperability between different collateral locations in order to use the current marketplace more efficient.
Seagroatt: It is not yet clear whether we will actually see shortages of collateral. However, as more firms fall under the uncleared margin reform rules around initial margin (IM), and pension fund clearing exemptions end, there will most likely be an increase in collateral demand. In the event of localised shortages, it is more a case of being able to unlock and mobilise collateral efficiently to where it needs to be when it needs to be there.
Looking at ways to increase interoperability between triparty agents, custodians and central securities depositories (CSDs) could help to reduce localised collateral shortages and unlock fragmented pools. Initiatives such as collateral highways that enable the more rapid mobilisation of collateral across jurisdictions with minimal operational risk, and friction costs are one solution to these problems. Peer-to-peer networks are another area that could supplement traditional intermediaries as a way to transform collateral.
We are also seeing the emergence of a number of collateral exchanges and these platforms could help to match available collateral supply with collateral demand more effectively. Finally, a number of firms are engaging in proof of concepts around Blockchain platforms for mobilising collateral. It is still early days, but there may be benefits to employing a blockchain solution that increases settlement efficiency.
As regulatory demands call for more margin to be posted, is the industry opening itself up to new risks by looking at less traditional sources of fixed income?
Grimonpont: This is not necessarily new for the industry and the implementation of the new regulatory requirements has been ongoing for some times now. This is definitely a place where third-party collateral management service providers like ourselves or through our joint venture with DTCC can help to reduce the risks for the industry. We can do this by ensuring proper asset classification, thorough management of thresholds and concentrations, proper and frequent valuation, and so on, and automatic substitutions when a given security falls outside of the pre-agreed eligibility profile. This allows parties to a trade to properly assess their risks and price it properly.
Kadikar: As long as the new collateral is being valued correctly with proper haircuts and operational support, and so forth. I wouldn’t say this means there is more risk in the system. Rather, it seems that by increasing available collateral the system would be more flexible and efficient and by extension liquid. Complexity shouldn’t necessarily be confused with risk.
Verrillo: The Elixium solution uses traditional and standard legal (global master repurchase agreement) and operating/settlement procedures. Anti-money laundering/know-your-customer checks are conducted on each counterparty with whom you are introduced and credit allocated, as you would now.
The only difference is that the range and type of potential counterparties and execution methodology is different — this gives you additional liquidity, better pricing, transparency and optionality, to the standard market in the form of capacity/connectivity and pre-trade anonymity via the platform. Counterparties retain full control of with whom, how and on what terms they wish to trade.
Are beneficial owners, such as corporate pension funds, at a disadvantage by not being able to leverage equities as collateral in the US?
Emily Kalbag: Yes, I believe so. The misalignment affecting beneficial owners in US securities financing is creating a disadvantage, especially considering that the US has the largest securities lending market and so is fundamentally long in equities. Not being able to leverage equities as collateral increases funding cost to the affected organisation due to the need to source alternative assets to use as collateral and scaling down choice. It has also been raised by industry bodies that the acceptance of correlated collateral, particularly equities against equity collateral, allows beneficial owners to optimise balance sheet usage and benefit from increased spreads. As equities have a determined price at any point and can be sold quickly, they are highly effective as collateral.
Which side of the transaction chain is driving the collateral trend towards non-cash?
Frei: From a credit risk perspective the major advantage of non-cash collateral is the segregation. Buy-side clients especially face issues with non-segregated cash collateral as they usually don’t have a direct central bank access and limited ability to reinvest cash. Furthermore, new regulatory requirements like mandatory variation margin will lead to an increase in non-cash collateral as many buy-side clients were not a part of the collateral market before.
However, I will not expect a big move to non-cash for the collateral requirements between banks, if rates are not increasing substantially. Still, a major benefit of cash collateral is the good ability to automate the entire collateral process, which is currently much less automated and therefore more time consuming for non-cash collateral.
Kalbag: This is driven by the buy-side. The buy-side typically aren’t long in cash- their models work around being fully invested so they need to go to market to obtain cash to respond to margin calls—either by selling or repurchasing assets or using a collateral transformation service. This incurs transaction costs, transformation fees, creates counterparty credit risk (for repo), takes time and detracts from investment strategy to deliver maximum returns. It would therefore be optimal for such organisations to use assets held in their inventory, assuming they are eligible and haircuts are not too restrictive. This would also prevent cash heavy portfolios, which may exceed mandated limits and prevent high returns, and avoid operational costs associated with interest processing. Banks are increasingly allowing the buy-side to collateralise with non-cash due to competitive advantage over their counterparts.
Verrillo: There are various forces converging on secured funding markets: regulatory, in the form of the liquidity coverage ratio, net stable funding ratio, and mandatory margining of over-the-counter product; and structural, ie, quantitative easing, the move towards collateralised lending and ring-fencing etc.
The combination of some and/or all of the above, can create dysfunctional and illiquid markets as traditional intermediaries no longer have the capacity necessary to provide the balance sheet for increasing demand.
The potential for more serious market dislocations, where collateral provision/transformation can be severely affected in stressed environments, is set out more comprehensively in a Bank of England staff working paper (No.609).
How can technology solutions help solve collateral challenges on both sides of the trade?
Kalbag: The increased complexity of managing collateral on a timely basis makes working through spreadsheets and siloed systems to calculate risk exposures and collateral requirements no longer practical, for buy- as well as sell-side businesses. The ability to streamline these activities while proactively managing asset values and margining processes can deliver greater efficiency and competitive advantage to the business.
Pre-trade analytics have become increasingly important with solutions to assist with the potential margin impacts of trading venues enabling IM efficiency, while taking into account existing portfolios and offset benefits resulting in a decrease in sourcing costs of eligible collateral. With an automated cross-product collateral management solution, what was traditionally a labour-intensive process can now be one of exception management-driving down costs and increasing efficiency.
Kadikar: There are still fundamental data gaps being experienced across business lines, operational functions and counterparties when it comes to understanding collateral. These gaps can include reference data, the real time physical location of collateral, traceability to the governing legal agreements and liquidity value of collateral. All of these gaps and more, can contribute to not only sub-optimal allocation decisions but also a lack of understanding between counterparties as to each other’s economic considerations when it comes to trading and subsequently collateral decisions.
Technology solutions that can harmonise data across these collateral silos and then validate the efficiency of collateral usage decisions will not only add significant value to the whole trade lifecycle (for both parties) it will empower collateral decision makers to work together more effectively. For example, on the collateral receiver side this may mean lower operational costs, lower error rates and engender more confidence that credit exposures are properly accounted for and arguably generate higher risk adjusted fees. On the giver side, enhanced technology also translates to lower operating costs but also means more flexibility around what is available to pledge to maximise regulatory as well as liquidity and operational efficiencies.
Seagroatt: First and foremost, technology solutions can provide major benefits around reducing risk. In a period of market disruption, firms have more control over counterparty credit risk, collateral quality and concentration risk when using a modern real time collateral system vs legacy systems or spreadsheets.
A good technology solution can also make it easier to source eligible collateral quickly when required and can significantly reduce operational and settlement risk.
As demand for high-quality collateral increases, a solution that allows collateral managers to gain a clear view of available inventory and exposures across business lines can help to match collateral supply with collateral demand at low cost, especially when employing collateral optimisation techniques.
Regulation is also resulting in an increase in operational workload due to a higher volume of margin calls to more demanding settlement cut-offs. Automation and straight through processing are key to adapting to these challenges while minimising increases in headcount. Improved connectivity between collateral management systems with a wide range of market infrastructure including triparty agents, central counterparties (CCPs)/clearing brokers, custodians, peer-to-peer platforms, reconciliation services, margin messaging tools and data benchmarking services also provides benefits around data aggregation, automation and straight-through processing.
From a regulatory reporting perspective, vendors that can offer reporting on collateral for the Securities Financing Transactions Regulation and the European Market Infrastructure Regulation/Dodd Frank will also help to ease the burden of compliance. Finally, the centralisation of collateral management and improvements in data management from using a state of the art system allow the ability to employ pre- and post-trade analytics to improve strategic decision making around collateral usage.
Verrillo: Innovation, both in the cleared and uncleared environment via CCPs (sponsored clearing) and CSD’s (using the collateral highway for example), can help to provide additional routes to mobilising both cash and collateral.
Frei: Collateral is usually held at different locations. Even within a single bank you could face problems to have a centralised view about all collateral available. A centralised near-time view about available positions and current exposures is key for an efficient collateral management. Without technology support there will be increased costs for the operational doing, sourcing additional collateral, and missing opportunities.
Furthermore, margin call matching services can lead to less manual communication and reconciliation effort. Important here is to have enough counterparties available on those services in order to achieve economies of scale while operating such a setup.
Grimonpont: Without surprise, I would mention the safe and efficient technical, operational and legal framework provided by the triparty collateral management service providers. But they can solve only part of the problems in the whole post-trade processing chain and new service providers are popping up that ease the process upstream. Peer-to-peer or all-to-all platforms are offering easier and transparent trading venues. Acadiasoft provides an efficient tool that enables, among others, portfolio and margins reconciliation in a scalable way. EasyWay contract management, a Euroclear service, brings collateral contracts and their administration into the digital age. Global Custodian are teaming up with triparty agents to give access to triparty solutions that were previously not reachable for some buy-side firms, etc. Additionally, the emergence of distributed ledger technology and other innovative solutions are equally interesting as a way to solve some of the problems encountered by the industry.
What part can all-to-all trading platforms play in improving collateral liquidity?
Frei: Operational efficiency is important but even more it is key to have access to all available positions. On centralised all to all platforms the problem of holding positions on distributed locations with limited re-use possibilities would be reduced. With that effect the market can gain accessible collateral liquidity.
Verrillo: By facilitating the flow of cash to collateral, and vice-versa, Elixium seeks to ‘release’ liquidity from counterparties that previously may or may not have been engaged in secured financing activity. We are facing a democratisation in financial markets, a sort of anti-big-bang if you like—the opportunity to re-engineer and create a better marketplace for all, is now.
Grimonpont: The key word here is ‘transparency’, meaning capacity provided to non-banks to compare prices from bilateral repo, triparty repo, securities lending (with or without an agent) on several asset class, with different trading protocols, such as fixed/floating/open rates, evergreen, and with or without right of substitution, haircut etc.
Seagroatt: All-to-all platforms can provide one mechanism for sourcing liquidity and there is growing interest in them as an alternative for traditional intermediaries. The key will be to gain enough volume to attract a wider user base through network effects. It seems unlikely that all-to-all networks will completely disintermediate sell-side providers but will become simply another route to market.
What implications could Brexit have on collateral use in the EU?
Grimonpont: It’s probably too early to tell but one could fear a further segmentation of existing collateral pool and collateral demand. Hopefully not to a point of major disruptions but in Euroclear, we are looking at all possible scenarios and we are developing new services to ensure we continue to support efficiently the mobilisation and allocation of all assets, whether held in the ICSD (Euroclear Bank), the UK CSD (Euroclear UK and Ireland) and the various Target2-Securities markets while integrating into the bigger picture which includes Asia and the US.
Seagroatt: There are a number of factors at play and it depends how things pan out but it could result in higher costs. The degree to which EU clearing can still take place in the UK could have a major impact for example.
Verrillo: It is very difficult to envisage an environment through which Brexit could give advantages to secured funding markets from a global perspective.
Fragmentation and disruption of liquidity, in any form, will take time and careful thought to recover from and protect against.
Elixium S.A. was recently launched in Paris to drive our European initiative and we remain committed to unlocking liquidity, creating efficiencies and improving returns in the secured financing markets in all jurisdictions.
Kalbag: It is difficult to tell what implications are likely until the UK decides how much of the EU law it wishes to keep. However, it has been made clear by the EU that only members who pay into the EU budget have access to EU’s financial services single market. As a result, London being the location of choice for global organisations to operate their European business out of, it is likely to change. In September, Moody’s downgraded the UK’s credit rating an additional notch, with Moody’s stating the weight of Brexit on the economy as one of the primary reasons. The UK was initially stripped of its AAA rating in 2016 and now holds an Aa2 rating with the agency. This affects the creditworthiness of counterparties with exposure to the UK, which increases the cost of credit and could lead to increased collateral requirements or even trigger default events depending on the individual agreements.
