An article in Futures and Option World entitled “OTC Clearing IV: How to ease the collateral squeeze” (May 21, 2012) caught our eye. Most of it is the usual stuff on the coming collateral squeeze, but the part on collateral transformation was really interesting. The article said the appetite to provide the service by banks and broker/dealers was fading away. Is this just on the clearing side of the house and could securities lending and repo desks be backing off too?
Not long ago the prospect of swapping a client’s ineligible collateral for the stuff that a CCP would accept made securities lenders and repo desk salivate. Long-term trades would provide nice annuities and revive an industry that hasn’t really recovered from Lehman going bust. We had been skeptical about the securities lenders involvement. Many derivatives are long term, requiring a commitment for CCP eligible collateral that could cover years. Securities lenders are, by their nature, short-term lenders. While they can say with some certainty there will be a core amount of eligible securities over the long haul, the exact amounts are hard to predict. We thought structured repo desks that have experience with long-term deals that can adjust over time better suited to handle this. We wrote about that issue here.
Well it turns out that fewer banks than were initially presumed have much appetite on the bank or broker/dealers side for transformation trades. While we continue to hear banks promote collateral transformation, particularly from the securities lending side, we’ve also heard stories about clearing agents telling high quality prospective customers that they won’t help them out with collateral transformation trades. Could this just be two sides of the bank not coordinating well? At beneficial owners conferences we’ve attended the remark about collateral transformation that stuck with us was “lots of people are talking about it, not a lot are doing it,” (OK, it was the same trader who said it at two different conferences, but it was memorable), and early data from our 2012 asset manager survey also show that mutual funds and insurance companies are thinking about the issue. A related post is here.
The FOW article quoted Minling Chen of financial service consultancy Baringa Partners, “What we are hearing from our clients is that as they start to work out the capital implications and the impact on their balance sheet of offering [collateral transformation] to their clients, the benefits of doing so might not add up.”
If fully accurate, this would be a pretty big change from one year ago when banks were gearing up for a big push in the collateral transformation area.
Ted Leveroni of Omgeo was quoted, “Six months ago, every brokerage or bank worked on the assumption that collateral transformation was something they could provide, but as they started to look at this in more detail, they realized that it was not a simple issue… Firms may not have access to the cash or sovereign debt they need and so they would have to borrow those assets. The largest holders of sovereign debt, however, might not want to engage in a transaction whereby they are opening themselves up to that level of credit risk with a single fund.”
Ted is a pretty knowledgeable guy and came to OMGEO from State Street’s collateral management group. If he is saying that banks are balking, at least as relates to the clearing side of the house, then we will take him at his word.
Once the CCPs have finished figuring how to include all the safe assets possible as collateral (the article mentioned that LCH.Clearnet, the CME, and ICE Clear Europe accept gold), the pressure will start to rise. It can be relieved in a couple ways: either the collateral that CCPs accept is widened out to include less safe and/or less liquid assets, more institutions receive exemptions from clearing swaps centrally, customers decide to trade fewer cleared derivatives, or investment portfolios will have to shift to include CCP eligible assets. The first two of those options should not sit well with regulators. The third should garner attention since this means exposures simply aren’t hedged. The fourth option — adding eligible assets — won’t rock any investment manager’s world when UST 2 year notes earn less than 30bp.
Finadium produced a report on the expansion of collateral options in March 2012 looking especially at corporate bonds and equities. We also wrote about widening out the acceptable collateral net here and here.
The other option is to improve on cross margining. This holds great hope to optimize collateral, but so far it hasn’t extended cross-border. New York Portfolio Clearing (a joint venture between NYSE Euronext and DTC) has “one pot” margining which includes NYSE LIFFE futures and FICC-cleared cash and repo (and hopefully soon to incorporate LCH.Clearnet swaps) is an example. The CME is doing the same with Eurodollar and UST futures and swaps. We wrote about that here and here.
We have one clarification we want to provide to the article. Sanela Hodzic, managing director of strategy and business development at Calypso was quoted as saying, “…There are a number of key changes from the fact that bilateral markets do not post initial margin down to the fact that CCPs only accept certain types of collateral….” Bilateral markets typically require posting of initial margin and more mandates for minimums are on the way. That is what independent amounts in CSAs are for. Swap agrements with sovereigns, supra-nationals and the occasional corporate may waive the requirement (but, ironic as it may be when it comes to sovereigns and supras, that won’t be the case is CCPs), but all other customers pay up front (with variation margin along the way).
Will this be the train wreck you see coming but can’t do anything about it?
A link to the article is here.