Speaking at the Futures Industry Association meeting in Chicago, Craig Donohoe, CEO of the CME, noted that more collateral upgrade trades would need to occur for central clearing of OTC derivatives to become a broader reality. Comments from a major exchange head serve to bring collateral upgrades to the fore, particularly for non-specialists who are just beginning to get their heads around the subject.
According to a recent Finadium survey, many derivative end-users engaged in the over-the-counter (OTC) derivatives market have begun to review their operations and technology, including the need to select an OTC derivatives clearing agent. Part of that analysis includes evaluating collateral upgrades, also called collateral conversion or collateral transformation trades, to supplement their scarce supply of cash and government securities for posting to a central credit counterparty (CCP) or when needed to bilateral counterparties.
As of this writing, the major central credit counterparties are willing to accept only the most liquid securities as collateral for trades; the common definition is anything that can be liquidated at face value within 59 minutes. More technically, CCPs are looking for margin coverage that meets a 99% confidence interval over a five-day or more trading period. This criteria currently limits collateral to two types: cash and government or similar securities; neither corporate bonds nor equities are on the list. In the US, treasuries are considered the lowest risk and least expensive non-cash collateral. In the futures markets, other products are accepted as margin but with greater haircuts.
Pretty much every securities lending and repo desk out there smells blood when thinking about collateral upgrade traders, which have the ability to inject substantial new capital into these markets. Having the CME start to talk about collateral upgrades makes the matter more serious for end-users.
For more information, please see an August 2011 Finadium report on insurance companies and the collateral upgrade trade.