Fitch: Collateral Transformation Drives Central Clearing Risks

Fitch posted some commentary today on their view of risks coming from the collateral transformation trade:

The shift away from over-the-counter (OTC) derivative contracts toward clearing via central counterparties (CCPs) may drive new business opportunities for large banks, but changing collateral posting rules could also create new pockets of systemic risk, according to Fitch.

We believe the move to central clearing will likely increase collateral requirements for end users since the benefits of netting derivative positions will be reduced as trades are cleared via multiple CCP operations. At the same time, clearing organizations will require market participants to post more cash collateral to mitigate counterparty risk in the clearing process. This will in turn lead to increased demand for collateral transformation services offered by CCP member institutions — the banks.

The regulatory rationale for the switch to central clearing centers on the desire to create a buffer of safety through margin requirements, which would lead to reduced counterparty risk and some delevering of swaps trading. The goal of regulators is to dampen systemic risk and reduce volatility in derivatives markets.

We believe that when central clearing is fully implemented, many end users may have difficulty meeting the cash collateral requirements of the CCPs. Dealers, particularly those tied to higher rated banks, are evaluating ways in which they can transform non-eligible collateral, such as corporate bonds or equities, into CCP-eligible collateral to meet the increased demand.

However, provision of collateral transformation services could potentially magnify large banks’ systemic importance in derivatives transactions, further complicating financial linkages among large institutions. They could also add complexity and blur transparency around relatively straightforward transactions. These risks should be weighed against potential problems faced by end users if cash collateral cannot be secured from banks. This could increase transaction costs and ultimately reduce liquidity in derivatives markets.

The simplest way to achieve collateral transformation is through reverse repo operations, where dealers engage in secured lending against ineligible CCP collateral. To make this business profitable, dealers would need to be able to fund these assets at a lower rate than they are lending. Providing collateral transformation through reverse repo could potentially cause meaningful balance sheet growth, and would also increase capital and possibly liquidity requirements at the banks. This may ultimately prove to be a material enough impediment to prevent meaningful collateral transformation services from developing or growing.

As a result, firms are exploring ways to act as intermediaries for their clients, while limiting their balance sheet exposure. We will monitor the evolution of these activities and will likely adjust bank balance sheets to reflect the economics of these transactions, even if they are able to achieve off-balance sheet treatment. It is also unclear what, if any, regulatory response may result from the growth of collateral transformation.

We note that there are other important considerations in evaluating the impact of collateral transformation services on dealers. In particular, the question of how firms will manage liquidity risk during times of market stress is critical.

This would be especially important if access to repo markets is constrained, or if haircuts on collateralized assets are increased and asset valuations deteriorate quickly. We also believe that an assessment of how dealers’ operational and counterparty risk-management infrastructure will absorb the additional business is an important factor to be considered in evaluating the potential credit impact of collateral transformation services as they grow in importance.

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