Collateral matters: the new value chain for collateral
- The increased need for high-quality collateral has transformed the collateral value chain
- Institutional investors face the challenge of balancing their collateral needs and liquidity requirements
- Getting the most value out of collateral requires an integrated solution to optimize its use
Historically, the role of collateral was to secure loans with assets that matched their monetary value. These then served as a lender’s protection against a defaulting borrower. However, its function has evolved over the years, and collateral now constitutes an essential component of financial markets for financing and liquidity. More recently, new margin requirements for over-the-counter (OTC) derivatives mean that it plays a major role as a tool for regulators to mitigate systemic risk, with significant implications for pension and LDI managers. How can asset managers optimize their collateral allocation in light of the challenges posed by new regulation?
The introduction of European Market Infrastructure Regulation (EMIR) in Europe and the Dodd-Frank Act in the US has transformed the role of collateral for institutional investors. The requirement to centrally clear OTC derivatives is a key element of both EMIR and Dodd-Frank, as are the increased margin requirements on non-cleared OTC derivatives (phased in over 2019-20). This includes the introduction of initial margin (the amount of collateral required to open a derivatives position) and tighter rules on variation margin (the amount required to adjust a derivatives position in response to daily market movements). These new requirements have forced banks, pension funds and insurance companies to revisit their collateral models, as they introduce substantial challenges with regard to managing liquidity.
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