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OTC clearing and its impact on collateral management

Part 4

Authors: Kersten Martin Meyer and Tom Riesack

Collateral: banks, broker-dealers, funds and clearinghouses all need it more than ever. Collateralisation of bilateral as well as cleared OTC trades is essential to ensure a functioning and stable financial market that is able to absorb potential shocks of Lehman-esque dimensions. Upcoming regulations like Basel III, Dodd-Frank and EMIR and margin requirements for non-centrally-cleared derivatives will enlarge the required collateral pool considerably.

Isn’t there plenty of collateral available already? Not exactly! Estimates from various sources suggest that the additional collateral necessary to cover the rising demand is between $2 trillion and $4 trillion. With cash collateral being the most expensive but also most successful option (i.e. being fungible, reusable and easy to manage operationally) the expansion of collateral types under consideration as part of the Basel Capital Adequacy Consultative document will see an increased use of diverse collateral (eligible instruments like government bonds). This change will lead to new requirements like complex collateral valuation tools.

But there is currently a squeeze on what is acceptable collateral in today's volatile trading environment. This could make maintaining collateral an expensive proposition. Long gone are the days where there was plentiful high-grade sovereign debt available. The International Monetary Fund predicts that sovereign downgrades will reduce the supply of general collateral by $9 trillion by 2016.

Clearing houses, looking for alternatives, are starting to also accept gold bullion and high-grade corporate bonds but this is only the tip of the iceberg. Clearing brokers are offering their clients collateral transformation services to swap non-eligible assets into cash, albeit at a cost.

As a consequence financial market participants need to re-evaluate the way they are performing collateral management today. A siloed approach to collateralisation looking at collateral for repo, listed products and OTC products separately for example, won’t work in the future. It is essential to use available collateral to your best advantage but this is only possible if there is a holistic company-wide view on collateral management, as close to real-time as possible.

Collateral management needs to be viewed not as a cost centre but rather as a provider of an invaluable service to the trading function and to clients alike. Moving along the maturity model stages collateral management might even become a profit centre by utilising re-hypothecation, optimised collateral/netting as well as collateral ‘upgrade’ trades.

Next week our OTC clearing blog series will look at reporting requirements to trade repositories and the unintended consequences in this area.



Comments: (2)

A Finextra member
A Finextra member 27 September, 2012, 14:47Be the first to give this comment the thumbs up 0 likes

The ability to net across ISDA, GMRA and OSLA based contracts for collateral has been a pipe dream for a long time. It has yet to materialize properly as the internal structure of banks is siloed and contracts are rigid. I am not sure that the current downgrade in assets will change these structures. 

With regard to collateral type acceptance, securities as collateral has long been accepted practice in Europe (although not so common in the US). Advanced models, gross haircuts, concentration limits and optimisation engines are all available from the major players (JP Morgan, BoNY etc..) as well as some suppliers.

Personally I am not a big fan of rehypothecation. Didn't we get ourselves into enough trouble with CDO's ?!??

A Finextra member
A Finextra member 28 September, 2012, 12:29Be the first to give this comment the thumbs up 0 likes

Terry, thanks for your comments...

I do agree that re-hypothecation is not without its own risks but broker-dealers offering transformation services will need to find ways to enhance their revenue stream and this is one of the more straight-forward things to do. So, like it or not, it is here to stay...

And with regard to collateral type acceptance: in yesterday's published technical standards for EMIR, ESMA will allow for transferable securities and money-market instruments to be used as collateral provided, among other requirements, these have been issued by an issuer that has low credit and market risk. Bank guarantees – including commercial and central banks – can also be used as collateral. But other than that it's only gold - so risikier collateral would need to be agreed upon with bilateral counterparties.

Best regards, Tom

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