A wave of unfamiliar nomenclature is sweeping financial markets: “collateral transformation”, “collateral upgrades” and “collateral swaps”.
These services are a first-draft attempt to give derivatives users access to the high-quality liquid assets that will be needed in a post-reform world trying to protect against the kind of turmoil seen in 2008.
“We see collateral transformation as an emerging industry,” says Supurna VedBrat, co-head of market structure and electronic trading at BlackRock, one of the world’s largest asset managers. “It’s developing mainly because future margin requirements are expected to be higher, and therefore the need for collateral transformation will be greater than what we currently require.”
Under proposed rules in the US and Europe, swaths of derivatives trades will have to be processed via clearing houses, which will stand behind these trades in the event that a counterparty defaults.
Users of these derivatives will need to post so-called initial margin, which can be liquid securities such as cash or government bonds, to send their trades to these central counterparties (CCPs). They will also need to provide “variation margin”, depending on swings in the trades’ value, and this can only be done in cash.
The problem, according to clearing members, is that many derivatives users, such as pension funds or mutual funds, will not have enough eligible collateral to satisfy the requirements. Morgan Stanley and Oliver Wyman estimate in a report that more than $2,000bn of additional collateral will be needed for over-the-counter (OTC) derivatives trades headed for central clearing in the coming years. A paper from the Bank for International Settlements has said variation margin may be more of an issue.
“The CCP must be safe, and to be safe it has to have very good collateral to prevent systemic risk,” says Hélène Virello, head of collateral management at BNP Paribas Securities Services. “The problem is that buy-side clients don’t necessarily have this collateral. Pension funds and regulated funds don’t have that much cash in their pockets.”
So, to generate the collateral needed to satisfy margin requirements, companies such as BNP Paribas Securities Services are considering offering collateral transformation services to their clients. This would involve clearing members, custodian banks or prime brokers turning their customers’ less liquid assets such as corporate bonds into CCP-eligible securities like cash or government debt through stock lending or the vast repurchase, or repo, market.
“A client that has a portfolio of corporate bonds, for example, could just take those bonds and do a repo themselves, to get the cash,” explains Ray Kahn, head of OTC clearing at Barclays Capital, which is considering providing the service. “Collateral transformation is really just building that collateral repo into the clearing process with more efficiency.”
Some expect the service to be big business. Morgan Stanley and Oliver Wyman forecast collateral transformation and risk management services will drive much of the revenue growth in capital market infrastructure in the next few years.
The new services are not without their critics. The repo market, where firms can lend securities in return for cash, seized up in 2008, eventually helping to push Lehman Brothers into collapse. Some banks planning to provide collateral transformation say they will not be able to provide unending liquidity to clients in the event repo markets falter.
“Dealers can’t do unlimited amounts of collateral transformation. We’re figuring out the right amount,” says Mr Kahn. “There are financial implications [for banks offering these services], both balance sheet and capital, which is what takes time to figure out.”
Ms VedBrat says: “My expectation is that as the custodians, prime brokers and clearing members look at providing collateral transformation services, their modelling will take into account periods of stress. They will have to decide how much is safe to do, what type of collateral to accept and what are the appropriate haircuts.”
Such calculations will prove crucial because, once Dodd-Frank reforms take effect, banks that get it wrong could, ironically, exacerbate systemic risk rather than alleviate it.