Collateral has become a focal point for financial institutions. While in the past the capital markets enjoyed abundant collateral and liquidity, the ongoing financial crisis has spawned regulation and risk management principles which are forcing a collateral lockdown. This in turn has prompted fears of a shortage of high quality collateral; although estimates of the size of any shortfall vary, this could have significant implications for market processes and prices.
As we have all experienced in recent years, the Dodd-Frank Act, Basel III and the European Market Infrastructure Regulation (EMIR) introduce greater demands for collateral. The central clearing of OTC derivatives under Dodd-Frank and EMIR calls for contracts to be collateralised and higher liquidity buffers to be put in place.
One disturbing strand of emerging thinking surrounds the notion that collateral management has become a commodity product. This presents fresh risks as it plays a central role in the control of counterparty risk exposure and the mitigation of both market and operational risks.
While changing attitudes to existing portfolios may be thought of as an opportunity by some collateral management providers in the short term, capitalising on such attitudes may lead to greater market risk.
As high-quality collateral becomes scarcer, most institutions are understandably concerned that the cost of such collateral will rise. Should some financial institutions be willing to accept low-quality collateral simply because it is cheap, some collateral management providers may be prepared to compete on the quality of collateral they accept, sparking a race to the bottom.
Our own research indicates that investment institutions place more importance on clarity and ease of use of collateral than cost. While cost will always be an important factor, it is critical that the capital markets do not compete on collateral quality. Collateral must be simple, of a high quality, liquid and easy to value.
Collateral plays a pivotal role for a growing multitude of financial services and products. It lies at the heart of securities financing, is a key enabler of risk mitigation solutions such as the credit valuation adjustment (CVA) and can even open up new revenue streams.
Regulatory efforts to protect the financial system are placing demands on collateral for both the buy side and the sell side. These demands are occurring at a time when banks are unwilling to lend. Central banks’ quantitative easing also plays a role in reducing the flow of eligible collateral, with a sizeable amount locked up in their reserves.
Compounding doubts around whether enough high quality collateral exists for the markets to function properly is a further question: is collateral where it needs to be in order to meet demands? Firms must note that the issue of collateral mobility is no longer simply about maintaining efficiency but also about ensuring that markets are safer than in the past. However, the problem remains the same. Whether the collateral exists or is simply stuck in the wrong places, the issue is one of scarcity.
There is a premium involved in simple, high-quality, liquid and easy-to-value collateral, and many institutions are willing to pay that premium. Given the recovery environment in which banking still operates and the less-than-positive outlook financial institutions feel over the future, this is not altogether surprising.
The sell side and broker dealers have always regarded collateral management as a key function due to their reliance on securities financing. In today’s changed environment, collateral management has moved from a back-office function to a board-level concern for retail and wholesale banks. As it grows in importance, some financial institutions believe that collateral management is shifting or has already shifted to being a commodity product. This could be dangerous.
Commoditisation is the process in which products and services move to a market of undifferentiated price competition. While commoditisation may be desirable for uniform items such as petroleum or electricity, collateral management offerings differ greatly in many other factors besides price – such as risk mitigation, operational efficiency and ease of use.
The direction it takes in the future will naturally depend on the markets. If they choose an external collateral management provider, will market participants choose the cheapest provider or seek out providers with value-added differentiators?
In addition, financial institutions are worried that in the race to find more collateral, some institutions and collateral management providers are securitising and repackaging existing portfolios to create new collateral pools. This could result in additional risk and potentially sow the seeds of the next big financial crisis.
Whichever direction the industry takes, the repackaging of existing portfolios is surely not the answer. Much of the crisis of 2008 has been repeatedly attributed to the repackaging of portfolios of subprime US mortgages. The fact that the financial services industry is even contemplating repeating the sins of the past is cause for deep concern. The financial markets need to be as transparent as possible: repackaging only leads to opacity and incomplete views of risk exposure.
Many investment institutions choose to use the services of third-party post-trade service providers for their collateral management needs. However, financial institutions are struggling to understand the pricing structures of the post-trade industry.
The opacity of the post-trade industry is obviously a major problem for financial institutions. Those post-trade service providers that make their fees as clear as possible to their customers should have an advantage over the competition.
One reason why market participants find the pricing structures of post-trade service providers so hard to understand is because there are so many factors to consider beyond the explicit ‘fees’ of the provider.
When deciding upon the choice of collateral management providers, the majority consider ongoing internal operating costs such as IT costs for maintaining the interface with the provider, internal staff costs and other factors. Most also consider the one-off upfront cost of implementation and onboarding.
However, just over half take into account the fees of third-party collateral management services, and only a quarter consider the cost of subsidisation of collateral management fees by the service provider. This latter element is a particularly tricky factor for financial institutions to consider. The issue here is that some collateral management providers may choose to offer fees that are artificially lower than the market average in the hope of getting the customer to pay higher fees for other services across the value chain.
Because it is recognised that collateral management providers bring simplicity and clarity to the trading process, investment banks are naturally interested in new providers who claim to offer a better proposition than they receive at present.
Bringing in a new collateral management provider is no easy task, and can take up to a year. The length of time taken to complete the on-boarding process and the complications involved in that process are in fact often cited as a reason to retain existing providers. Inertia and suspicion of the unknown win.
It is no surprise, then, that when investment institutions look for collateral management solutions, they choose functionality over cost. On average, the most important requirement of a system is that it covers central counterparty acceptance. The next most important factors on average are the ability to request segregation of margins, real-time settlement and real-time reporting.
It is clear that collateral management systems not only need to offer wide functionality, they also have to demonstrate quality and reliability. Again, this emphasises that these systems are premium products, and that cost is of relatively low importance.
Most firms said they were currently using a tri-party collateral management system, under which a third-party collateral manager assumes responsibility for administering exposures (pledged assets) and collateralising them using assets of the same value.
Most firms in our survey appreciated the benefits of such a system over a bi-lateral solution, citing reduced risk, ease of use due because of automation and a reduced cost because of a reduction in time spent on collateral management. Once again, cost is less of a concern compared to other benefits that such solutions bring.
There are several conclusions to be drawn. Collateral management is no longer only about maintaining efficiency but also about ensuring that the financial system is safer than in the past. We believe that collateral must display at least four key qualities.
Collateral must be simple. The repackaging of securities to create ‘new’ collateral pools is foolhardy. Complex securitisation practices make it difficult for financial institutions and CCPs to gauge obligations to counterparties. Simple collateral streamlines internal operations and provides transparency to the institutions and markets.
Collateral must be high quality. Regulators and CCPs must resist the temptation to make low-quality collateral acceptable. Credit rating agencies are not infallible but still provide a useful indication of creditworthiness.
Collateral must be liquid. CCPs need to remain bulwarks of stability if they are to reduce systemic risk rather than move it elsewhere. The collateral that CCPs hold must be liquid so that they can return it easily under times of market stress.
Collateral must be easy to value. Financial institutions need to easily value their own and their counterparties’ assets so that they can minimise risk. The messages to be taken away could not be simpler, and well prevent any possibility of another crisis in the near future.