There is a complicated matter on the horizon that is already affecting the willingness of OTC derivative end-users to post non-cash collateral on CCPs and that may confound the potential of the government bond for lower credit assets portion of collateral transformation trades.
The issue at hand is the possibility that non-cash collateral posted on any given CCP in an LSOC account segregation model will not be the same collateral that is actually returned at the end of the transaction. In practice, this means that if and investor posted UK bonds on CME clearing, at the end of the trade is possible that the investor would get French bonds back. It becomes then a difficult argument for a collateral manager at a mutual fund, insurance company or pension plan to claim that non-cash collateral is a hands-down better type of transaction than posting cash. For these investors, cash is still king as collateral for OTC derivatives transactions that clear on a CCP.
There is trouble however in how this cash will get raised. We stand by our previous estimates that centrally cleared derivatives will require an additional US$1 trillion in collateral to be posted over current amounts. While we also continue to think that there is no net collateral shortage, there certainly are costs to acquiring the right collateral whether buying outright, selling assets for cash or in lending out assets in a collateral transformation trade.
Investors that want to post cash on a CCP for the security of receiving that cash back in the same currency it was posted have to find that cash somewhere. Our conversations suggest that while individual firms have no trouble, the industry of OTC derivatives end-users as a whole do not have enough cash at all.
One viable solution for firms without enough cash is to lend out securities in the market in a lending program designed to generate cash. These programs will cost some money but may be less expensive and safer than a collateral transformation trade where the investor lends the same assets, raises government bonds, posts those bonds on a CCP, and runs the risk of not receiving the same bonds in return.
Let’s look the economics of the transaction:
Presuming the investor holds high-quality corporate bonds that have no particular value in the securities lending market (and that can’t be posted directly on a CCP as in the CME’s program), it stands to reason that the fee paying by a borrower would be negative, ie, the investor has to pay to lend out the assets. Presuming this fee to be, say 20 basis points, the investor then receives cash back at a hypothetical 102% and can post the cash on the CCP.
In another transaction, the current going rate of posting corporate bonds as non-cash collateral in exchange for government bonds is in the 50 to 70 basis point range. This means that the same investor lending out high-quality corporate bonds and getting back government bonds in exchange is paying 50 to 70 basis points.
Obviously the first transaction is currently the better deal but there is a limited supply of investors willing to receive 20 basis points in order to take these corporate bonds and do little with them. We see this market deteriorating quickly as more investors with corporate bonds try to take advantage of this trade; we think pricing will move quickly to the same 50 to 70 basis point range or even higher than lending the corporate bonds in exchange for government bonds. This suggests that investors that lock in a long-term (1-3 year) corporate bonds for cash securities lending trade, even paying fees up to say 40 basis points, should be able to keep costs comparatively reasonable while minimizing their risks of posting one kind of collateral and getting back another.
We think that the issue of what kind of collateral can be safely posted on the CCP is beginning to be thought out by the buy-side and even in some cases on the sell-side. It is no longer just cheapest-to-deliver; there are only risks and rewards to consider as well. We expect to hear more in the future about creative collateral-driven transactions that maximize return while reducing risk.