This article previews an upcoming Finadium research survey on insurance companies, fund managers and the process of collateral management. In particular, we look at manager thinking on collateral efficiency and portfolio strategy, non-cash vs. cash and the value of trading collateral.
Within their management of collateral, insurance companies and fund managers must set a range of policies that determine how collateral is segregated, what collateral is posted and who actually manages the process. The 32 funds we spoke with typically kept their collateral in-house or with a custodian. This was not a pressing topic and the conversation quickly turned to cash and non-cash collateral management.
A drive towards collateral efficiency ultimately translates into portfolio strategy; managers are aware of this and are working to plan for their futures. In one case, a manager acquired a major collateral management technology platform in order to drive a more robust portfolio management strategy. This acquisition went beyond just collateral movements to look at netting and investment opportunities. Another new factor is how much collateral goes to each futures clearing firm. This used to be a non-issue, but following the collapse of MF Global, it is now considered an important risk metric. Ultimately managers will track not only what collateral is held by which clearing agent, but also which clearer accounts at CCPs could affect portfolio margining determinations.
Fund managers today are prioritizing cash in their collateral dealings with outside parties; 64% of funds posted cash only for their OTC derivatives transactions while the remainder posted both cash and non-cash. No fund posted only non-cash. These figures align with ISDA data on collateral holdings; in April 2014, ISDA reported that banks received 75% of their non-cleared OTC derivatives collateral in cash and delivered 78% of their own collateral in cash.
All of this cash does not preclude insurance companies and fund managers from using non-cash, it is simply that this has not been the pattern so far. In their cleared OTC derivatives activities, managers reported that they would like to increase their non-cash use, particularly in corporate bonds, but that they have met resistance from selected clearing firms. According to managers, some clearing firms have more appetite for risk than others, or, we believe, have more flexibility in either posting non-cash directly onto CCPs or in conducting collateral transformation trades at a competitive cost. One manager is trying to conduct a collateral transformation trade as a test; there is no immediate demand, just the theoretical question of whether such a trade could be conducted at all.
We heard divergent views about the value of trading collateral. On the one hand, managers said that collateral is there to mitigate risk, and that is its sole purpose. When collateral is rehypothecated (traded) for the purpose of generating additional revenue then its role in risk mitigation has been compromised. According to one executive, “Collateral is supposed to be about mitigating risk. When it becomes a trading or revenue opportunity through rehypothecation then that comprises the liquidity of the collateral, which is the reverse of risk mitigation.” Another group of managers talked actively about trading collateral and though this would imply rehypothecation, it did not seem to be viewed that way by the managers thinking about trading opportunities.
For the time being, managers reported having enough cash that questions about trading collateral, collateral transformations or needing extra high quality securities is not a concern. The bigger questions will arise when two trends collide: first, an increase in interest rates that requires insurance companies in particular to post Variation Margin whereas today they are on the receiving end; and second, a slow but steady rollover from non-cleared to cleared OTC derivatives positions that requires more collateral as Initial Margin. This process may take five to ten years, but ultimately the collateral that insurance companies and fund managers need to post will be substantively higher than today. This is not a topic that managers yet need to concern themselves about, but at least a few managers recognize that a day of reckoning is on the far horizon.