Custody Risk: What is Euroclear trying to do differently?
Olivier de Schaetzen: We are positioning ourselves as an open infrastructure provider. We want to offer the market a robust and scalable infrastructure to which securities service providers can channel their clients’ business in a safe and tested environment. We are developing our collateral management platform into a ‘Collateral Highway’ to extend our scope of collateral sourcing to cover securities finance, derivatives, CCP margins and central bank liquidity, among other segments.
Custody Risk: And are you trying to get the central banks heavily involved?
Olivier de Schaetzen: It is a key strategy for us to leverage the long-standng relationships we have with central banks as custodians of their fixed-income assets to collateralise their open market operations – in Europe, the US and other countries as well. Central banks are key because they are the last link in the collateral chain, as are the CCPs. They are key to the Collateral Highway because they are the end of collateral flows. This is why we are trying to expand our activities with those entities. We have been doing collateral management for major CCPs in Europe for many years, but that has been to support broker-dealers in their repo clearing business or their swaps clearing business. In the future, even more flows will come through the CCPs, involving the buy side and custodians.
Custody Risk: Which upcoming regulation is the most significant in terms of suppressing the supply or putting pressure on the demand of collateral?
Sam Jacob: They are all tied to each other; it is not one issue alone. A combination of regulations – from Dodd-Frank, Emir, Ucits and Basel III to the Alternative Investment Fund Managers directive – are driving this increased demand for collateral.
Olivier de Schaetzen: Basel III’s liquidity regime, particularly the introduction of the LCR for banks, means that the need to hold liquid assets will be significant. However, all the new regulations are going in the same direction and pushing for more collateralisation. Emir and Dodd-Frank will impact our clients in a different context, which means they will be looking for collateral management solutions beyond the conventional securities financing business.
David Béatrix: Dodd-Frank and Emir require collateral to be exchanged by their own because of the clearing requirements on a bilateral basis, through what Emir calls risk mitigation techniques for non-cleared trades. The initiative of the WGMR for non-cleared trades asks whether bilateral independent amounts should be exchanged between parties on a bilateral trade, so these are very direct effects. Basel III will make unsecured transactions much more costly for the parties engaging in OTC derivatives transactions, especially due to the credit valuation adjustment (CVA), which worries participants about how much it is going to cost for unsecured transactions and whether they have to collateralise. In addition, there is a funding issue on unsecured relationships or entities that are in one-way a collateral agreement, where you have a distortion between what the dealer has to pay for collateral on the hedging transactions and what he really receives from its clients. There are side effects, but the market is moving towards collateralisation even for those that are not collateralised yet. On the corporate side, many people are looking at the European Parliament to find out whether the corporates are going to be exempt from the CVA obligation, because one of their main worries is how much their OTC transactions are going to cost in the near future.
Custody Risk: Can you give guidance around the risks involved, such as pro-cyclical margin?
Sam Jacob: At the start of these transactions, we are seeing a lot of questions specific to risk. These include questions around where the assets are being held, how you are diversifying, who is holding the collateral and what happens in the case of default. There is a huge demand across market participants for an independent or neutral third party to provide these types of collateral management services. And then there is venue selection: given the different collateral impacts of one market versus another, what is the ultimate impact going to be? Providing these services can help enable clients to more effectively manage risks in their portfolio.
Custody Risk: How are you making it easier for market participants to access and move collateral?
Sam Jacob: The key is greater flexibility. There is going to be an increase in the cost and in the demand for high-grade collateral, but to what level will depend on how much the market ultimately takes off. If the market takes off and the requirements are up in the trillions of dollars, then you are going to see an increase in demand and a subsequent shortage of collateral in the market. But, if those numbers are not as high, then this will be less of an issue. If there is a shortfall, then obviously the costs will rise. However, several efficiencies around the management of collateral can be provided to market participants to allow them to access and manage their collateral process in a cost-effective manner, while also supporting their needs around essential services such as segregation and optimisation.
Olivier de Schaetzen: The mandatory clearing of OTC derivatives trades will create a new clearing value chain. Buy-side clients will have to mobilise securities as collateral for their derivatives transactions to be cleared through a CCP. There will be a need to identify and transfer the right collateral, with the support of their custodian and clearing member counterparty, to the CCP. We can use the existing infrastructure we already have in place for securities financing purposes to meet these new demands. Our collateral reuse facility will be particularly helpful to clearing members, who will be sourcing collateral from the buy-side customer through its custodian for reuse with the CCP. And, we have the technology to ensure full segregation of collateral flows and full traceability of securities for all parties. From dashboards, they can identify which piece of collateral belongs to which counterparty and for which transaction. It is important to be able to trace and segregate assets in a safe environment for asset protection. We have all the components needed for this new clearing value chain. We will leverage our existing and proven collateral management infrastructure and develop it for derivatives clearing.
Custody Risk: And would a move to same-day settlement help? Is this going to happen?
Sam Jacob: We would ideally like the markets to move to same-day settlement but, given that there are many different infrastructures across the globe, we are not convinced we are going to get there in the short term. But same-day settlement would be a very good thing for the market in the long term.
David Béatrix: The move to same-day settlement would facilitate the process, but there are technical difficulties. Most custodians are capable of internally making collateral transfers on the book-to-book basis because that is the concept of the Collateral Highway. If the market infrastructure is moving towards a same-day settlement, that would facilitate the transfers of securities between institutions.
Olivier de Schaetzen: Same-day settlement is not an easy job in practice. The devil is in the details, especially with so much collateral fragmentation, particularly in Europe. You need the right pipes everywhere to ensure that securities collateral can move as easily as cash.
Custody Risk: Will we see a return to unsecured lending in money markets?
David Béatrix: Probably not. Given the financial crisis and the environment, which implies that risk managers are constantly looking at credit risk, it is not what will happen. It is not going to be the major trend even if collateral becomes scarce, so we may be even more in a position to see a larger eligibility rule in terms of collateral rather than going straight to unsecured lending on the market.
Olivier de Schaetzen: The only unsecured lending we may still see will be on the very short end of the curve, such as overnight. Beyond that, lending will almost always be secured. That is the trend we have observed over the last four years – a migration away from the unsecured to the secured, which is increasing the reverse repo market. Many money market funds, for example, are moving away from outright investment to reverse repo investment, and a large number of corporates are looking to take away banking deposit risk from their treasuries with reverse repo transactions to secure their money.