This article, “Guarding against collateral shortfall,” by Susan Kelly appeared in FierceCFO this week. It is a good summary of how CFOs should think about collateral issues these days, and we don’t say that just because we are quoted in it!
Guarding Against Collateral Shortfall
January 27 2014
New bank capital requirements and regulations on derivatives trades could lead to a shortage of collateral. One recent warning on this topic came from the Depository Trust & Clearing Corp., which put out a white paper last week estimating that margin call activity could increase from 500 percent to 1,000 percent over the near term.
Projections of the additional collateral required range from $800 billion (the Bank of England’s estimate) to $10 trillion (ISDA’s estimate), according to the white paper.
Mark Jennis, managing director for strategy and business development for colateral management at DTCC, said while there’s some increase in demand evident now, “the concern is more what’s going to be happening in the future, when you have all the clearinghouse requirements and initial collateral and the like.”
“Given that there is this huge demand for collateral, is there enough supply to meet that? It depends,” he said. “There are a number of different tools that are out there that may help in terms of the ability to meet that requirement.”
Such tools include “the ability to pledge other types of collateral beyond what’s standard today, for example, money-market funds,” he said, and collateral transformation, a process in which a company exchanges securities that don’t qualify as collateral for higher-rated securities.
Jennis also cited the need to integrate the various workflows and infrastructure that are used to manage collateral to better handle the huge increase in volume that’s anticipated.
While gloomy prognostications about the collateral market have been a staple for the last few years, a recent Reuters article noted the cost of collateral still isn’t showing any strain.
“There are not yet really signs of stress, but we are in the very early stage of positions moving from bilateral not-cleared [trades] to cleared on [central clearinghouses],” said Josh Galper, managing principal at consultancy firm Finadium.
Galper argued that the various factors determining supply and demand in the collateral market will take years to play out. “Corporations might find their cost of collateral has increased substantially, and that would affect how much they’re willing to engage in OTC derivatives trades,” he said.
Both the Dodd-Frank Act in the U.S. and EMIR in Europe will result in more clearing of derivatives trades, and when a trade is cleared, collateral must be posted. While Dodd-Frank’s end-user exemption allows some corporations to continue trading derivatives bilaterally with their banks, Galper said he expects companies to switch to centrally cleared trades as Basel III capital requirements make bilateral trades more costly.
He argued that companies need to get ahead of the situation by assessing their use of collateral and what collateral they have available to see whether they are likely to have a problem. “There are multiple factors to consider, both in their holdings of assets and what other needs the corporation might have for the assets,” Galper said. For example, the company might have assets that could serve as collateral but already are pledged for other purposes.
“It’s also important to recognize where collateral management falls,” he said, whether it’s handled within the treasury department or the responsibility of a dedicated collateral management team.
“The trick is to not be in a position of it coming as a surprise,” Galper said. “Then you have to take costly actions.”
The original article is available here.