The transition to cleared swaps has generated a lot of analysis on collateral shortages. If an investor doesn’t have the right kind of collateral – say they have corporates but need Treasuries – that creates a need for collateral transformation. Many players in the financing world – securities lenders, repo desks, and prime brokers – are standing ready for the demand. Yet others have wondered why they haven’t seen much interest from clients for collateral transformation trades. We’ve heard “lots of talk, not much action”. We think this is a matter of timing.
Preferential capital treatment will encourage dealers to move existing bilateral swaps they have with clients onto a cleared platform. New trades that can be cleared will be cleared. But what does that mean for collateral demand? Take insurance companies who have used derivatives as a way to go long risk. They have been held up as the poster child for collateral transformation. Long-term trades put on at higher interest rates will be deeply in the money, creating large surpluses with clearing members. This means that the investor’s clearing member will be receiving the collateral when the trade is put onto a CCP. Not a lot of demand for collateral there – actually the opposite flow. The dealers, however, now have to collateralize their exposures since they will be out of the money. Dealers have much easier access to eligible collateral and probably don’t need collateral transformation per se.
Insurance companies will eventually need to pony up collateral when new trades, interest rates spike, or both absorb their surpluses in the CCPs. But until then, we’re skeptical if collateral transformation by insurance companies is the next savior of the financing markets, at least in the short term.