Custody Risk: Can you provide a specific example of collateral movement?
Sam Jacob: Say we have a large margin call for a buy-side client and that client wants to deliver a piece of collateral that has a T+2 settlement cycle. Once we receive that piece of collateral, we can facilitate the pledging of that collateral without having to go through additional settlement cycles from the buy-side client to the dealer or futures commission merchant, and then on to the CCP. We do not have to wait for additional settlement cycles, so clients do not have to wait for additional settlement cycles to fund liquidity. It is much more efficient than physically moving the collateral across the various market participants.
Custody Risk: What collateral is going to be in the greatest demand, and will the costs of accessing this collateral increase?
Olivier de Schaetzen: We have seen an overall flight to quality in the collateral spectrum – in the securities financing business, repo business and securities lending business. The demand for quality collateral is increasing dramatically, and we are sure we will see more collateral being channelled to CCPs. And, by the nature of their systemic importance, they need to be very careful in terms of collateral profiling. CCPs will limit the eligibility of collateral to the top end of the collateral curve, which will increase pressure on that segment. And there is a growing need for collateral givers that do not hold such assets to find solutions to upgrade the collateral they have in order to reach CCP eligibility levels to fund their activities. As a result, we foresee collateral transformations as being key for some firms. Another aspect to acknowledge is the impact of the recent rating downgrades on sovereign bonds. Downgrades of previously top-quality collateral sovereign bonds are decreasing the size of the pool of eligible collateral, which typically satisfies the criteria for CCP-eligible collateral. So, on one hand, we see a growing demand for collateral and, on the other, a shrinking supply of the right collateral. You don’t need to be an economist to understand that the cost of collateral will go up.
Custody Risk: Some people might call it a collateral crunch.
Olivier de Schaetzen: Given the growing need for collateral and the speed of downgrades, there is a risk that top-quality sovereign bonds will be scarce, so there will be a collateral crunch in that specific sector.
David Béatrix: It is going to be gradual because regulations are likely to make high-quality and liquid assets become quite scarce. The overall expected shortage of collateral is linked with European Market Infrastructure Regulation (Emir) and the Dodd-Frank Act, where a lot of collateral, and especially securities, is going to be required to meet those margin requirements and for which reuse is going to be limited, so circulation of collateral is decreasing. The impact of Basel III, especially for derivatives, is likely to make assets less available because banks are going to be required to have more high-quality and liquid assets to meet the liquidity coverage ratio (LCR) and, therefore, it is also likely to reduce the scope and volume of collateral in circulation.
Custody Risk: What collateral do you think is going to become the best value for money or attract the most demand going forward?
David Béatrix: The government bonds from very highly rated countries are likely to be the most in demand. We have seen historically low yields on those bonds. It means the equation is quite difficult because, if you go away from government bonds, then risk and issuer risk on your collateral increases. And, if you move to cash, then you have asset protection issues. So the equation is difficult to read, but consensus is that government bond issues are going to be a sought-after area.
Custody Risk: How is it going be easier to get hold of eligible collateral?
Sam Jacob: CCPs accept different types of collateral and they are not harmonised across the board, so first we need to realise that not all of the institutions executing OTC trades have the exact type of collateral that is acceptable to every CCP. We are moving from sovereigns to corporates and we will stay within the realm of some corporates that will be utilised in the clearing world. This alternative collateral market will start to take off as more trades move into the cleared space. I believe we are going to see more high-grade collateral, like corporate bonds and other fixed-income instruments, becoming eligible for long utilisation.
Olivier de Schaetzen: There is a need to find ways of accessing the right supply of eligible collateral, for example, highly rated government bonds. We see many firms already trying to tap new sources of collateral in that segment. Finding institutions holding these assets – such as pension funds, sovereign wealth funds or central banks – and engaging them to enter into collateral swap agreements will enable firms to swap the collateral they have for CCP-eligible collateral. Such collateral transformations will increase in the future. There is a lot of dialogue now about tapping into new pools of collateral. Because demand will increase, there will be increased opportunities for holders of quality collateral to earn attractive fees when swapping collateral.
David Béatrix: There is the need for greater flexibility in the collateral eligibility matrix. Swapping collateral against other collateral implies that, if you want to make an upgrade transaction, you have got something that is a bit lower grade. If you look at the recent long-term refinancing operation, the European Central Bank has released some of the constraints on the rating criteria of some asset-backed securities transactions. That is not proof, but there is a trend appearing that, given the scarcity of high-grade assets, the eligibility matrix will need to be released at some stage.
Custody Risk: Will the more people you bring into the process – more pension funds and sovereign wealth funds – mean there is going to be more risk in the system?
Olivier de Schaetzen: Obtaining access to high-quality collateral will have a price. The price is the remuneration for downgrading the quality of the collateral giver’s overall holdings. It will always be a question of risk/reward. It is true that the holders of government bonds are buying them for their safety, so they are not going to enter into swap transactions where they are massively downgrading their overall holdings. So, collateral transformations with a given counterparty will be limited. On the other side, we could imagine a CCP to marginally – and only marginally – relax its collateral eligibility criteria. As we have seen so many downgrades from some agencies of major countries, CCPs will need to consider whether their collateral criteria of accepting just AAA and even AA+ rated bonds can be amended to take a limited portion of collateral issued by countries that have recently been downgraded to AA.
David Béatrix: If you don’t increase the number of high-quality and liquid assets in circulation, you will still have to loosen eligibility rules. And then you have got side effects that are becoming more prominent – you have more volatile collateral, liquidity of collateral and more frequent valuation issues. Operational risk and risk around collateral management is likely to increase with the amount of collateral that is increasing. On one hand, you have the regulators and the IMF, which recommend CCPs should allow for a broad range of collateral and, on the other, the volume of assets available as collateral is not increasing as quickly as collateral is required.
Sam Jacob: Not necessarily and, from an operational perspective, we’re not doing anything out of the norms of how we operate today. If a client is holding a particular type of asset and wants to convert it, then there are several mechanisms we can provide to help clients to achieve this. But, from a collateral management perspective, we do not direct clients specifically to which collateral they need to be holding or which mechanism to choose. The eligibility requirements will be established via negotiation with the clearing houses. So the CCPs will determine which type of collateral is required for eligible trades, while the dealers – based on their risk management guidelines and regulations – will determine the type of collateral they will take for non-cleared trades. As it relates to the position that the clients are holding, you either have it or you don’t.