Is the collateral upgrade trade a red herring?

A panelist at the Clearstream global securities financing conference said this yesterday in Luxembourg, and while deliberately poking at the current groupthink, he had a real point. There is current excitement about the collateral upgrade trade as a silver lining in a sea of bad news. Regulations create new winners and losers and this is another example. However, there are several reasons why collateral upgrades, while certainly a potential positive, may also not be as good news as the market is looking for.

The notion of collateral upgrade trades is exchanging corporate bonds, equities or other products that are unacceptable to a CCP or other counterparty, and getting instead treasuries or sovereign debt that the counterparty will accept. This trade has been going on for a while and is expected to grow substantially as OTC derivatives move onto CCPs. For the most part, CCPs want cash, treasuries or sovereign debt, and end users have to get them to make their trades happen. Finadium wrote a big piece on the collateral upgrade trade from the perspective of insurance companies last summer.

As the speaker noted later, there are a few holes in the current thinking about why collateral upgrades will take off en masse. The first starts with the underlying client that needs the upgrade trade. The client may have a 30 year interest rate swap and may need to post collateral for that trade on a CCP. The client goes to the OTC derivatives clearing broker and asks for the collateral upgrade in exchange for their corporate bonds or equities. But, they want a guarantee that the trade won’t be unwound, maybe not for 30 years but certainly for a long time. This is a very unrealistic desire and one that your average clearing agent can’t necessarily meet.

The reason is simply that clearing agents won’t usually be holding the inventory in house to make the collateral upgrade happen. Instead, they will go to an agent lender and ask them to make the trade. Although the broker can get a term trade for six months or a year, at some point the underlying asset holder is going to sell the desired collateral and need to unwind the trade. It is probable that the broker can redo the trade with the same or another agent with a different underlying asset holder, but the costs may vary. It is also possible that the broker can’t do the trade again. The broker knows this and will tell the client upfront that there won’t be a guarantee.

So the client hears “no guarantee” and instead of accepting the best that they can do, they may look for another product that doesn’t require the good collateral or not do a trade at all. Hence, the collateral upgrade trade doesn’t happen.

In another scenario, the estimated $1 trillion (Finadium, Oliver Wyman) to $2 trillion (Tabb Group) in collateral that needs to be dredged up to post on CCPs may not materialize in the right places and times. In this case, even with a willing underlying client the trade can’t happen. As one example, a large plan sponsor we spoke with recently has moved their minimum spread for treasury lending to a pretty big number, meaning nothing is going out the door. If too many funds take this road, the treasuries held by those plan sponsors won’t get lent.

All of this is speculation but the fact remains that the collateral upgrade trade is not a done deal. There are multiple moving parts and not all of the actors have agreed to play their parts.

Of course, if the Fed suddenly starts QE3 (or QE4, or QE5), and continues their repo program for treasuries, they could become the good collateral lender of last resort. That would be ironic since they helped create the need for high quality collateral in the first place…

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