The assumption that central clearing of OTC derivatives will promote healthy collateral transformation opportunities has been called into question by several observers.
The cost of collateral transformation may deter buy-side firms from using OTC derivatives as a risk management tool, while the lack of industry-wide transparency on available collateral could hamper the necessary automation of collateral management processes.
Mandated changes in OTC derivatives clearing are seen as likely to promote a surge in securities lending and repo activity as participants hunt for high quality collateral to support their trading activity.
“If the buy-side is going to be forced into compulsory clearing of their derivatives transactions towards the end of this year, they will obviously need to come up with the appropriate margin, both for CCPs and their bilateral trades,” says Saheed Awan, global head, collateral management and securities financing at Euroclear. “If they don’t have the right collateral, they will need to exchange whatever assets they have, such as corporate bonds and equities, for the right collateral. The market’s expectation is that we will see a surge in collateral upgrade volumes as a result.”
Margin calls are likely to increase, both in volume and number. “What banks have done so far, in line with regulations, is to exchange collateral reflecting changes in market value – so called variation margin,” explains Tom Riesack, managing principal at consultants Capco. “What they haven’t done before is put up initial margin and that can be quite a significant amount if you are a smaller bank.”
The belief is spreading that in the year ahead an aggregate collateral shortfall will emerge as a result of regulatory changes, though estimates vary wildly. “There’s no common agreement among analysts about whether there’ll be a shortfall, how big a shortfall there might be or when it might hit,” says David Little, head of securities finance at Calypso, a provider of collateral management and optimisation solutions. “The range is massive, from $2-30 trillion.” Little attributes the difference partly to the anticipated impact of netting: a small drop in netting efficiency could drive up the shortfall significantly.
Awan sees the problem as largely one of silos rather than overall shortfall. “We don’t actually think there is a shortage of collateral in aggregate,” he says.
A fair price
Awan though sounds a note of caution. “I’m really very concerned that intermediaries are waiting for this new build-up in demand to come and are expecting a great deal of money to be made as a result,” he says. “I think, all of us in the securities processing and financing industry have to be very careful that we do not overcharge for collateral management services generally, and collateral upgrades specifically. The cost of collateral services has to be at a level that makes business sense for the buy-side as they move their derivatives trading business to CCPs and put up the required margin.”
A similar warning comes from Craig Pirrong, professor of finance and energy markets at the Bauer College of Business, University of Houston.
Blogging under the moniker, Streetwise Professor, he observed recently, given the cost of collateral, “the large increases in initial margin will require derivatives users to choose between continuing to use them to manage risk, but obtain lower returns, or to eschew derivatives and live with greater risk.” He suggests nevertheless that the true systemic risk inherent in clearing and collateral mandates lies elsewhere: the contingent needs for liquidity to make variation margin payments. “Big price moves lead to big variation margin flows. These will tend to occur when markets are stressed and liquidity becomes scarce,” he says. “Thus, the need to make variation margin payments will exacerbate stresses on the market…Given that financial crises are, typically, liquidity crises, this is a major systemic problem.”
From an operational perspective, meanwhile, it is not just the volume, but also the number of margin calls that will need to be taken into account in designing an efficient process. “The market is clearly moving towards a daily revaluation of derivatives positions and therefore the collateral that’s required to cover it,” says Tony Freeman, executive director of industry relations at Omgeo. “That will generate a huge number of margin calls.”
“One of the problems is that there is no transparency around available collateral,” says Peter Axilrod, managing director, business development, DTCC. “Securities aren’t held in such a way as to make it clear.” He points out that at central bank and CSD level, securities are typically held in an omnibus account. “Then of course the larger banks have holdings all over the world,” he adds. “There just isn’t the system in place right now to make it clear who owns want.”
As far as collateral transformation itself is concerned, Axilrod raises another warning flag: that collateral transformation typically uses up bank balance sheets. “Will they see that as good use of their balance sheet in a crisis?” he ponders.
Reporting by Richard Schwartz