Collateral as catalyst

Although many aspects of the post-trade costs of centrally cleared OTC derivatives to the buy-side are still hard to pin down, it is increasingly apparent that large asset managers are adapting to the new environment in a way that smaller institutions will find it hard to replicate.

One of the biggest challenges for all investment institutions is going to be coming up with the necessary collateral demanded by central counterparties (CCPs) when they start clearing liquid OTC derivatives like interest rate swaps, replacing asset managers’ existing bilateral arrangements with the sell-side. CCPs typically accept cash and investment-grade government bonds, but these – especially the latter – are in diminishing supply. Moreover, they’re not the kind of assets investment institutions like to line their portfolios with on account of the impact on their asset allocation preferences. The solution to the problem is collateral transformation – swapping the collateral you do have for the collateral that the CCPs want.

The difficulty here is the cost of the exercise to the firm that seem most able to help, ie custodians and prime brokers. Broadly speaking, the collateral transformation service provider takes available assets and transforms them via securities lending or repo transactions into collateral acceptable to CCPs. Custodians already offer securities lending and repo services to clients but the cost of managing potential collateral mismatches is proving so expensive that the buy-side is balking at the extra cost. Given that end-2012 marks the start of a long process under which more and more OTC derivative instruments will be gradually harmonised and standardised and made fit for central clearing, a number of global asset managers are taking the long view by hiring traders to set up repo desks and handling collateral transformation needs in-house.

A number of changes have made buy-side firms among the biggest players in certain OTC derivative asset classes, for example credit default swaps. As the decline of leverage has limited demand from the hedge fund sector, the need to provide improved and sometimes tailored outcomes, for example through liability-driven investment products, has increased participation in the OTC markets among traditional long-only players.

For those larger firms, the buy-side repo desk makes sense, but what of the rest? It may be that increasing competition between custodians and prime brokers chips away at the cost of collateral transformation over the next 12-18 months or so. But it may also be the case that such services are wrapped up into a broader investment operations outsourcing proposition. Several custodians are already ramping up investment in their service offerings. With many asset managers finding they have less money to spend on execution in the equity markets, could it be that OTC derivatives reform becomes the catalyst for a more thorough cost/benefit analysis of trading and related investment process?