Its time to build a collateral and liquidity strategy

Financial market participants of all sizes have moved out of the tactical phases and now need to focus on creating a long term collateral and liquidity strategy. This will require a change in attitude about what collateral and liquidity means at many institutions. The task is made easier however by rational expectations of what regulations have meant for financial markets and what might be expected going forward.

We are witnessing a series of movements that lead us to the same conclusion: now is an ideal time for financial market participants including banks of all sizes, insurance companies and corporations to create a collateral and liquidity strategy that will endure for some years at their organizations. We have now moved past an important operational phase where getting the processing and legal agreements right were the priorities. Sharks have been jumped and the emergencies have largely receded.

We are also passed the majority of regulatory unknowns. While some potentially damaging conversations are still out there, for example the Financial Transactions Tax and mandatory buy-ins in Europe, for the most part we expect that securities finance and liquidity will continue to be important parts of financial markets. This includes not just posting collateral for OTC derivatives but reaches as well into lines of credit, repo, securitized products and settlement.

Actually creating the strategy requires a robust understanding of what an institution has available versus what it means today and may need in the future. For the sell-side, this means gathering all available assets together and pricing collateral. We already see a sharp division in banks that have an active collateral pricing strategy and what that means for their provision of liquidity across business units. While the pricing methodology may be argued one way or the other, the fact is that these institutions are working off of expected and predictable rules. That is to their benefit. Meanwhile, organizations that lack an understanding of the cost of collateral and liquidity are heading quick for trouble. This will impact their ability to calculate regulatory capital and the profitability of their business units.

The buy-side needs new financing and liquidity strategies too. We take the perspective that relying only on a revolving credit line with a bank is not the best idea. Not only are these lines expensive (a liability for capital ratio calculations) but they can be revoked at any time. That’s no way to run a business. A better plan is to assess what internal assets can be used as a source of financing in liquidity and how those assets can be mobilized for day-to-day operations or in particular times of need. Perhaps the most challenging aspect of this otherwise simple task in the need for by side silos to work together. We’ve encountered very few organizations that have yet to take on this momentous project and have already emerged successfully.

The only collateral and liquidity security we see now in the market belongs to anyone with a Central Bank account. Banks, some brokers and some CCPs worldwide now have this access; compared to their peers they are in excellent shape for reserve liquidity. Central banks are not exactly giving these accounts away however. Everyone else needs a better plan, and now is the time to get that right before fewer options remain.

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