Collateral burden drives mid-tier firms away from swaps

Continued uncertainty on the availability of collateral once new OTC derivatives rules kick in is leading some buy-side firms to exit the swaps market altogether, suggests the latest asset management survey by Ernst and Young.

Continued uncertainty on the availability of collateral once new OTC derivatives rules kick in is leading some buy-side firms to exit the swaps market altogether, suggests the latest asset management survey by Ernst and Young.

The firm’s ‘Compliance management for asset management’ 2012 survey – based on insights from 42 buy-side firms – found that 58% of respondents were worried about scarcity and quality of collateral.

Of the firms contributing to the survey, 43% of which were active users of OTC derivatives, 17% were liability-driven investment firms, 21% were exchange-traded funds providers, 19% were users of prime brokerage services and 12% were significant users of non-deliverable forwards and FX forwards.

A total of 36% of those questioned were in the process of examining brokers’ ability to transform assets into eligible collateral under normal and stressed market conditions. However, the survey also revealed that the buy-side is yet to be convinced of the collateral transformation services offered by custodians and financial market infrastructures, such as central securities depository (CSD) Euroclear’s Collateral Highway. Only 24% of survey respondents regarded collateral transformation services from financial market infrastructures as safe havens.

Under OTC derivatives reforms, enacted via the European market infrastructure regulation (EMIR) in Europe, standardised swaps will have to be traded on exchange-like platforms and cleared. This will force the buy-side to pay initial margin against swaps exposures for the first time and have processes in place to post variation margin on an intraday basis.

For some mid-tier firms, overhauling systems to handle the new margin rules may be too burdensome, leading them to find alternatives to swaps trading.

“Several mid-sized asset managers across Europe are going back to chasing traditional alpha through stock picking or sector bets,” said Anthony Kirby, executive director, regulatory reform and risk management, Ernst and Young. “It appears as though some firms do not want the hassle of dealing with the regulatory labyrinth to come, particularly those asset managers that don’t have technical resources or sophisticated systems to easily adapt to new rules.”

It is not only OTC derivatives regulation like EMIR and Dodd Frank in the US that will put strain on the supply of collateral, adds Kirby, with potential restraints on the repo market through shadow banking regulation currently under consideration by regulators globally.

Around 62% of those questioned in the Ernst and Young survey said they already had problems participating in the repo market, through issues to do with standardisation, market practices or documentation.

Concerns over collateral stem in large part from regulatory uncertainty.

“There is an urgent need to define generally acceptable collateral for derivatives trades under new legislation and what constitutes fungible collateral, i.e. whether the assets used for margin can be moved around under consistent operational market practices and legal treatments spanning multiple jurisdictions at short notice,” said Kirby. “It will then be easier to determine whether we need to ‘unfreeze’ dormant sources of collateral that are already sitting within firms, or pipe in collateral from other regions.”

Following the formal sign-off of technical standards underpinning EMIR in late February, central counterparties are expected to start liaising with the European Securities and Markets Authority to determine the collateral that be used for OTC derivatives trades.

If CCPs and regulators opt to limit eligible margin to cash and high-quality sovereign bonds, links between CSDs that safeguard assets will be crucial to ensure the smooth relocation of collateral globally.

“If collateral is transferred from other regions, this could raise new questions on CSD interoperability, not least as more global asset servicers enter the CSD space,” Kirby said. “But more importantly, title transfer, i.e. determining who owns collateral and for how long, will also become an issue under stressed market conditions, if the supply of collateral from other regions suddenly dries up. More studies are needed to model and provision for these risks before competent authorities rush to regulate the collateral and repo spaces.”