It’s an answer — of sorts — to the $2,200bn dollar question.
Avid regulatory watchers will remember that the central clearing counterparties (CCPs) due to arrive under upcoming collateral reform will require billions worth of high-quality collateral to be posted by users of derivatives. Where will it all come from? How to solve this collateral conundrum?
Ladies and gentlemen, introducing collateral transformation.
Clearing members say they have a solution. Most buy-side firms will have to access clearing services through these members – typically the large banks – due to strict membership criteria set by the CCPs. These clearing members are responsible for collecting margin from their clients and posting it to the clearing house, charging a fee for the privilege. As an additional service, however, a number of clearing members are also planning to offer collateral transformation facilities – essentially, enabling the client to post non-eligible instruments with the dealer, which will be switched into cash via the repo market and then posted with the CCP. Given the frequency of margin calls – there could be several per day in volatile markets – some also plan to extend credit lines, where they would meet intra-day margin calls, with the customer settling up in one go at the end of the day or start of the next.
It sounds a perfect solution, but the numbers involved are huge, raising the question of whether there is enough capacity and appetite among dealers to offer this service to the entire universe of end-users. According to research published by Morgan Stanley and Oliver Wyman on February 16, as much as 40–50% of the total annual traded volume of OTC contracts could be cleared by 2012/13 … creating an additional collateral requirement of between $2 trillion and $2.5 trillion … Most dealers say they would only have capacity to extend credit lines and provide collateral transformation services on a fraction of that.
A version of collateral transformation is going on already, but for a very different reason.
The Bank of England warned earlier this month about collateral swaps, sometimes known as switch trades. These involve banks striking a deal with insurers or pension funds to swap their illiquid assets for things like government bonds. The insurers and pension funds get a little bit of yield in a world of low rates. The banks get liquid assets that help puff up their capital ratios and they can use as collateral.
It’s a nifty tricky for a world lacking in sufficient, high-quality collateral.
Unfortunately it more than resembles a bait and switch, doing little to actually decrease risk. As the Bank of England has pointed out, in times of financial stress the firms may ask for more collateral from the banks, or for their lent liquid assets to be returned toute suite. The risk in the banks’ illiquid assets hasn’t disappeared. It’s just been temporarily shifted onto insurer and pension funds’ books.
The same could easily be said of the collateral transformation planned for clearing, only in reverse. Risk jumps from the clients’ books to the banks, who, we imagine, will do their utmost to sweat the assets. It’s no coincidence that the Risk article starts with a repetition of the law of conservation of energy.
Energy can neither be created nor destroyed: it can only be transformed…
The collateral crunch – FT Alphaville
It’s stock lending Jim, but not as you know it – FT Alphaville
Collateral transformation services key to buyside clearing – IFR
Collateral management for OTC derivatives – BNP Paribas