When writing this paper, we found that many of the situations and challenges we currently face in dealing with collateral optimisation are perfectly summarised by the key players in the cult 1980s rock music mockumentary ‘This is Spinal Tap’, who express similar feelings and emotions.
The recent history of the banking sector has caused similar levels of concern for many and no doubt a great deal of ‘freaking out’ in response to the seismic changes that have arisen in response to the 2008 banking crisis. The point to remember is that many financial institutions have managed to survive, despite the worries and the uncertain business environment they have been operating in.
The banking crisis was a dramatic tipping point: for the first time ever, liquidity virtually vanished. Funding spreads widened and demand for collateral dramatically exceeded available supply. Concomitantly, the realisation dawned that pricing should be based on short term interest rate swap benchmarks rather than LIBOR, unsecured term funding and liquidity became expensive and high quality liquid assets (HQLA) were in great demand and short supply. The very definition of what is a High Quality Liquid Asset came into question during the sovereign debt crises that followed. Declining asset values of both own name and inventory created consequent drains on liquidity as more and more collateral was required from the shrinking pool of HQLA.
Then, before the markets had chance to fully recover, along came Basel III with significant increases in Risk Weighted Assets (RWA) and hence further increases in demand for capital. The combination of higher costs, more onerous capital and collateralised trading requirements has meant those firms wishing to remain in derivatives markets need to look closely at their collateral processes as well as the control and economics of collateral. This translates into a stark but simple message: firms who fail to look at this – whether buyside or sellside – risk becoming uncompetitive.
The paper, “Turning up the dial: The challenges in developing a holistic collateral model,” can be found here with free registration.