Collateral, collateral transformation and CCPs: a close look at the crazy numbers

The figures on how much collateral will be necessary to fund initial margin in CCPs are all over the place. A September 10, 2012 Bloomberg Businessweek article quoted figures between $500 billion and $2.6 trillion, and this doesn’t count any high quality assets required for capital ratios or bilateral transactions. The inevitable conclusion is there will be a shortage of collateral coming that will impact the cost to move derivatives to CCPs. But this is only one dimension of the overall collateral picture. Exactly how much shortage however is a matter of conjecture; the bottom line impacts are still anyone’s guess.

Margin can be in cash or acceptable collateral. In a zero rate environment, where short term “good collateral” yields are next to nothing, it may be more efficient to use cash as collateral. Collateral transformation trades – much ballyhooed in the financial press as the way to deal with the collateral shortage – won’t be costless. A dealer swapping, say, corporates for Treasuries needs to pay for balance sheet, regulatory capital and the incremental cost of financing the less liquid paper (to say nothing of P&L). In the current interest rate and regulatory environment, the cost of the swap may be higher than using cash. Derivative players who can issue Commercial Paper or who have other cash sources might do very well on this trade.

The expectation that the collateral transformation trade will make up for lost dealer revenues of 20% to 40% of their current $170 billion, as suggested in the Bloomberg article, was a show stopper. 20% to 40% of $170 billion is $34-$64 billion. If it is $2 trillion of collateral transformation trades that will make up for $34 billion in lost revenue, the spread earned needs to be 170bp. Ummmm… The spreads on collateral transformation trades might be good, but they are nowhere near that good.

Collateral transformation trades are a shell game in who holds risky collateral, and the regulators already know it. The risk of the CCP-ineligible collateral now shifts to the dealer doing the trade, who then recycles the paper in bilateral or tri-party repo. The UK regulators, in particular, are already cautious about banks loading up on less credit worthy collateral. Dexia’s implosion was, at least in part, blamed on collateral swaps that everyone seemed to miss months before. These trades became illiquid and (in the pre-LTRO days) unfundable. The result might be for regulators to push investors into holding adequate CCP eligible collateral in their portfolios. While the cost will be high (in terms of having to accept lower portfolio yields), it may be the only option that avoids the risks of collateral transformation alchemy.  

One part of the analysis we have not seen much attention paid to is collateral turnover. High quality paper is re-lent in the market. Economist Manmohan Singh wrote that collateral velocity is like the velocity of money; clocking in at somewhere between 2 and 2.5. When you dead-end collateral in a CCP, it can no longer be re-used. When a collateral squeeze comes, it will be felt in this multiplier. We wrote about this in a blog post on July 3, 2012 “Singh and Stella on the velocity of collateral: banks just don’t trust each other. We think there is more to it.“ as well as in the March 2011 Finadium paper “Central Credit Counterparties, Margin and the Challenge of Collateral Management”. There is something else we not sure has been taken into consideration in any analysis: the role of derivatives portfolio compression. TriOptima’s work in reducing derivatives notionals, often dramatically, could also reduce the amount of margin the market needs as trades are ripped up.

We think there is a collateral squeeze coming, but CCP derivatives clearing is only one of the reasons and may not even be the most important one. There are many miles to go before we really understand the volume of collateral shortages as relates just to CCPs, and then you have capital ratios and bilateral collateral shortages. The IMF puts Basel LCR requirements for banks at somewhere between $2 to $4 trillion. Collateral segregation in the futures and prime brokerage world will remove lots of paper from re-hypothecation, further contributing to safe paper shortages. The numbers are big but a healthy amount of skepticism is still in order. We may not be from Missouri, but we still say “show me”.


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