More factors to consider on the direction of collateral transformation trades

First it’s the next big thing, then its a red herring, then clearers say they don’t want to do it, and now securities lending agents and beneficial owners say they are doing it and look forward to doing more. Where is the collateral transformation trade headed and what evidence do we have that it is getting there?

Although the FOW article on collateral transformation that we discussed yesterday made certain that clearing agents were balking at collateral transformation, we hear a different story from securities lending agents. These players are marketing their services and, from what we hear, are pretty sure that they can provide collateral upgrade trades to interested borrowers. We haven’t heard much about the maturity mismatch issues (an overnight treasury loan against a 30 year interest rate swap, anyone?) but the concept of collateral transformation in general seems to be holding steady.

We’re also seeing alternatives from banks on how to make a better collateral transformation trade. As one example, Citi put out a marketing piece (“Collateral Optimization: A Fund Manager’s Perspective”) earlier this year with their own take on the strategy:

“Collateral upgrade: An idea much discussed in recent months has been transforming ineligible assets, such as corporate bonds or equities, into widely accepted collateral. However, many of these solutions are based on secured lending lines from counterparty banks and are thus subject to the usual constraints of this type of transaction, including eligibility, cost, availability of balance sheet and commitment in times of market stress.”

“An alternative approach, which may be a good fit for larger funds with high-quality assets, is a three-month evergreen lending transaction in which the fund lends a portfolio of assets in return for cash and pays a spread to the “borrower.” This arrangement is typically brokered by a securities lending agent and has the benefit of providing a degree of funding commitment, without the need to liquidate any underlying positions.”

We also hear from beneficial owners in the US and Europe that manage their own fixed income books that they see genuine demand for high quality fixed income assets. Their observation is that the demand is broader than the need for CCP collateral and reaches into the need of banks for high quality liquid assets. This is not the sort of demand that is likely to fade quickly (unless the Basel Committee allows a much broader acceptance of corporate bonds and equities, in which case all bets are off). For beneficial owners with high quality fixed income portfolios, 2012 is shaping up to be a pretty good year, revenue-wise.

Taking these factors into account, we are leaning towards thinking that the collateral transformation trade offers good returns for the institutions that are able to conduct it. However, not every firm can simply raise their hands and commit to participating; this is a market only for asset holders with a ready supply of assets who don’t need to high quality assets for their own balance sheets. The players still on the sidelines are the repo desks: we haven’t heard much from them yet on this topic, and we did think that they were well placed to step in as either principals or middlemen.

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