An Oasis in the Desert: Collateral Management in a Funding Constrained World
By Radi Khasawneh, TABB Group
Originally published on TABB Forum
Market conditions and regulatory complexity have combined to make efficient management of collateral a critical component in a wider process of controlling trading and funding costs across the industry.
Market participants are caught in a pincer movement of regulatory-led market change that will make collateral management an increasingly crucial component of decision-making for trading desks and risk managers. This change has been driven by US and European regulations aimed at moving bilateral, over-the-counter (OTC) swaps onto exchange-like venues and through central clearing and a separate push by national regulators to impose renewed and more stringent capital calculations on the banks that act as the intermediaries for the buy side.
The net effect of all of this cannot be overstated. TABB Group estimates that shifting non-cleared OTC swaps to central counterparties will eventually require approximately $2 trillion in additional collateral deposits. And that is just one piece of the overall puzzle that means a more systematic attitude to the collateral workflow has to emerge. Alternative figures published last year by the DTCC put that OTC collateral figure at $4 trillion, showing how widely these estimates can vary. In any case, it is clear that the efficient use and management of collateral has become a key part of strategic thinking as the consequences of regulation are weighed.
To give an idea of the sheer scope of these figures, total collateral held against non-cleared OTC contracts at the end of 2013 was $3.2 trillion, according to figures published by ISDA. That figure includes the decline in non-cleared swaps as US and European mandatory clearing began to take hold; but 90% of those non-cleared swaps are subject to collateral agreements in any case.
Global clearinghouses have reacted to this by dramatically expanding the scope of their cleared products and enhancing the ability to net exposures across products and portfolios (as part of incorporating this new volume into existing flow). Nevertheless, the fragmented regulatory environment also has led to a proliferation of clearing entities across jurisdictions. Exhibit 1, below, shows the divergence in margin haircuts applied by global CCPs for the same securities. There is an obvious bias to home country securities (government bonds and equities) that can be posted, and the vast majority of collateral posted is in the form of either cash or sovereign bonds; but the extent of the differences shows that there is definitely scope for a change in approach to how collateral requirements are managed at global trading firms.
Exhibit 1: Margin Haircuts Applied to Securities by Global CCPs
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Source: TABB Group
Futures Commission Merchants (FCMs) have reacted to this by updating and enhancing their own technology platforms to allow clients to manage their own exposure through their platforms. In a survey of more than 50 US buy-side swap traders conducted last year, 33% of respondents said they selected their FCMs based on their technology platforms. Interviews with 16 FCMs conducted in the second quarter of 2014 showed that collateral management ranked highly as a strategic differentiator for firms (Exhibit 2, below); it also was the top area cited when asked to identify an area that would lead to the greatest increase in revenues for the business.
These positive trends are counteracted by a much more challenging funding environment overall. Sustained low interest rates have hit the performance of collateral reinvestment at firms (whether that is pure net interest income or passing through negative interest rates on cash balances), and the finalization and phased introduction of an Enhanced Supplementary Leverage Ratio (eSLR) in the US has had a seismic effect on bank attitudes toward balance sheet usage. The new calculation imposes a stricter, additional 2% capital buffer on bank holding companies and requires them to calculate notional, rather than netted, derivatives exposures in some cases. The leverage ratio denominator also takes into account off-balance sheet exposures that were previously not included. All of this adds up to a headache for firms designated as globally systemically important financial institutions (so-called G-SIFIs). In this year’s FCM interviews, nearly 90% of FCMs cited regulations – and specifically the SLR – as the key concern over the past 12 months.
Exhibit 2: Key Differentiators for FCMs, April 2014
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Source: TABB Group
What all of this means for the buy side is that higher collateral requirements will inevitably be accompanied by higher baseline costs, as fees are revamped to reflect the changing funding environment for banks. The Dodd-Frank Act in the US, the European Market Infrastructure Regulation and the Markets in Financial Instruments Directive (MIFID II) already have had a large effect on buy-side workflows (Exhibit 3, below). Rather than simply focusing on sourcing and tracking the correct form of collateral securities, firms are increasingly being offered the tools to optimize and analyze decision-making and valuation.
Exhibit 3: New Collateral Workflows
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Source: TABB Group
All of that being said, change has been slow in coming. There is a dependence on CCP models across the board, and 40% of US buy-side swap traders do not validate these valuations at all. FCMs have indicated that adoption of collateral analytics, although valued, has been slow.
TABB Group expects – and has argued for – the emergence of an expanded role for collateral-use decision makers at buy-side firms. There is a need for an ability to rapidly allocate collateral and optimize its use through efficiency in tracking, monitoring and managing collateral inventories across business lines. As these figures emerge, wholescale adoption of more sophisticated, global approaches at buy-side firms will have their champion.