On January 20th we posted “Is the collateral upgrade trade a red herring?“. This isn’t the first time we have written about the complexities of collateral swaps. Last October we posted “Derivsource: Collateral Transformation, Silver Bullet or Smoke and Mirrors”. We too questioned the maturity mismatch between long dated swaps which need collateral posted in CCPs for years and the short term nature of the Securities Lending business. We wrote,“One critical issue that isn’t mentioned is the maturity risk of the collateral swaps. Sec lending trades are, by and large, done on open or overnight. While sec lenders may anticipate always having a critical mass of eligible paper to feed the collateral swap, their custodian parents don’t typically have the ability to lock in the underlying clients holding. Eligible collateral borrowers need a contractual obligation from their lenders guaranteeing to have paper available for as long as their underlying derivative trades require. Collateral swaps are best executed as structured repo deals with negotiated terms controlling collateral diversification, term, collateral availability, rates, and haircuts.”
It bears repeating: while there is a wide variety of eligible collateral to deposit into a CCP and it is hard to think the paper will simply disappear — the economics are sure to change during the course of the trade, potentially with disastrous results. The Sec Lending arms of the custodians are not the place this business should be managed. Why? Few beneficial owners want to lock in their paper to loan for years on end. But the collateral going into CCPs may have to stay for quite a while. It is a very tough mismatch to manage unless you can guarantee the availability of eligible paper. Its not the nature of beneficial owners to do that. Of course, we realize that maturity transformation is the stock and trade of securities financing businesses, but this may be a bridge too far.
The collateral swap trade isn’t only about CCP business. In Europe, where banks need paper to go to the ECB, they drive the demand to swap out non-ECB eligible for paper the ECB will take. The BOE Quarterly in late 2011 addressed their concerns over collateral swaps and we believe they weren’t talking about CCPs but rather the ECB repo side.