Finadium: Sizing Up the Collateral Transformation Trade

Finadium has released a new report on the current and potential market sizing of the collateral transformation trade. Collateral transformations are a potentially important means for banks and OTC derivative end-users to access securities for bank balance sheets and posting collateral. This trade, where cash or government bonds are exchanged for a “lower” credit asset such as corporate bonds or equities, could lift securities lending and repo markets while providing a valuable service. However, the trade is not without its hurdles, namely the economics and number of willing and able participants.

In this report, Finadium breaks down the mechanics, asset availability and demand for collateral transformations on the borrower and lender side. Whether the trade is conducted as a repo or securities loan, the numbers reveal disproportionate supply and demand for each subsection of the market where collateral transformations might occur. The conclusions to this exercise provide important lessons on the size and impact of the collateral transformation trade for market participants and regulators going forward.

The relevance of the collateral transformation trade will depend on whether financial markets see a shortage of collateral for OTC derivatives and whether banks have enough assets to support their balance sheets. We conclude that while there is no absolute collateral shortage, a scarcity of cost-effective assets for purchase and holding has already led a portion of the market towards collateral transformation trades. This trend will continue strongly through 2013 so long as current regulations support a required increase in cash and government bonds for collateral and balance sheet purposes, at least until the costs of collateral transformations push up against other funding alternatives or even the cost of not conducting a trade.

Collateral transformations affect a broad cross-section of financial markets. As such, this report should be read by financial market participants that give or take collateral and their banks, securities lending agents, repo counterparties and technology providers. Institutions and asset managers holding portfolios of government bonds and money market securities, as well as regulators, will benefit from understanding the impact of collateral transformations on their investments.

This report is 33 pages with 12 exhibits.

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