An important question on the horizon is the use of cash in collateral management. Financial market participants have experienced a relatively relaxed cash environment over the last few years. Cash has been inexpensive; interest rates have remained low enough that placing cash as collateral to a bilateral counterparty or to meet obligations at a CCP has meant that few opportunities were missed elsewhere.
Eventually, this era will come to a close. This suggests two things: first, that non-cash collateral will become more important; and second, that technology will become a primary means for market participants to understand what collateral should be posted where, and when.
External data points indicate that cash is by far the most popular type of collateral utilized to meet margin obligations; ISDA’s 2013 margin survey showed that 80% of collateral received for OTC derivatives transactions worldwide was cash and 79% of collateral delivered was cash. In addition, our own surveys show a marked preference for cash collateral as well. Alongside these observations, current data including the Federal Reserve’s Senior Credit Officer Opinion Survey concurs: cash is the easiest collateral for market participants to deliver and receive.
There may be historical and business model reasons for the importance of cash as margin on derivatives. Margin was managed in the back office, where reaching for cash was the path of least resistance. Utilizing non-cash collateral typically meant understanding which securities were available and best to use, interfacing with securities settlement and involving repo and other collateral funding desks in decisions. Using cash was an easier transaction. As the migration of collateral management functions continues to shift, and the front office and firms realize the benefits of optimization, this dynamic will change.
Going forward we see three important factors that could fundamentally alter the cash vs. non-cash equation. The first is rising interest rates. Although still a theoretical conversation, there are continued suggestions of rising rates from both the Federal Reserve and the Bank of England.
Higher interest rates will reduce the validity of arguing that cash returns are too low to be interesting. While cash returns with higher interest rates will only be slightly higher than interest rates themselves, they will look better on paper than today, especially for pension plans that have an actuarial rate of return in the 6% to 8% range. When investors have alternatives to earn a non-zero return from cash instead of investing for a near-zero return, they will consider their options closely before posting that cash to a CCP or bilateral counterparty for anything less than an optimal outcome.
The second factor is that the duration of many trades may turn cash collateral into an unattractive property as per the Liquidity Coverage Ratio and Net Stable Funding Ratio. The more unattractive cash is from a possible net outflow perspective, the more it places stress on bank funding ratios (more details on that here). This may result in an extra surcharge on cash collateral posted with a dealer counterparty unless the dealer can show that the cash will be retained for more than a year.
A lack of interest in cash from a balance sheet perspective will raise the interest in posting non-cash as collateral. The logical decision for whether cash or non-cash is better will hinge on the cost/benefit of each choice; can treasuries be repo-ed out and the cash reinvested, or used in an Exchange for Physical Single Treasury Future trade? What else can be done with the cash on a reinvestment basis? This in turn will make collateral management analytics tools more important for investment firms and banks.
The third reason for participants to shift toward non-cash collateral is simply because they can. The practice of collateral management has become increasingly necessary as regulations increase the need to collateralize exposures. The sell-side has taken the lead with large technology upgrades to de-silo collateral and manage it across the firm. The buy-side is starting to do the same. As more available information on non-cash collateral results from a good technology solution, the more likely that non-cash collateral will be used.
The push towards non-cash has multiple facets, not all of which have positive momentum. For example, the CFTC requirement that CCPs have a repo facility for treasuries may result in a surcharge on treasuries posted as collateral and may make cash more attractive, all other returns being equal. Overall, however, non-cash will become a much more serious conversation for collateral providerss than in the current market. The cash vs. non-cash equation will be difficult to evaluate in real-time, making the efficient use of technology a market necessity.
Thanks to Broadridge for sponsoring this article and moving the conversation forward.