One of the perennial, challenging discussions at SIBOS is always centred on collateral.
T2S is symptomatic of the trend where prime collateral will be needed to secure formerly un-collateralised or loosely collateralised transactions. The migration of many OTC derivative trades, especially interest rate swaps, to central clearing creates further demand. And the trend, over time, is for the bulk of securities and derivative transactions to be market traded and centrally cleared wherever possible.
I have always been struck by some key issues in this debate. Is there enough prime collateral to meet the demand? How much netting will there be in the centrally cleared markets and what is its impact? How can the market improve collateral management? How will collateral impact market activity?
In an era where country downgrades have been plentiful and, as one colleague explained, “A” is the new “AAA”, there is a shortage of prime collateral. Everyone wants prime. Prime collateral is primarily cash and government bonds of a dwindling band of issuers. Luckily, they are all continuing to issue generously in this era of quantitative easing!
T2S uses central bank money and central bankers are intuitively wary of non-central bank risks. They therefore have a predilection for cash or government bonds as the only acceptable collateral. The algorithms to be used in T2S are not really clear and so it is hard to estimate exact collateral demand. However, past experience from the UK equity settlement platform, which is multi mini batch and therefore differs from the planned large batch overnight process in T2S, is that collateral demand is highly sensitive to the market timing of one’s counterparties in settlement as well as to the balance between settlement volumes in government bonds and equities.
CCPs, however, are also obliged to be risk adverse. They take on positions, net them out, at times offset similar but not identical transactions and are getting involved in an ever wider range of complex instruments. They are risk takers with volatility outside the standard norms being their greatest, and potentially life threatening, enemy. They take initial margin based on a mathematical analysis of instrument volatility over time and variation margin to allow for the delta between strike prices and markets. This is all very fine as long as the margin taken is accessible and adequate. Accessibility is the driver for the CCP preference for prime collateral, with cash predominating from the initial margin charge (although that creates redeployment risk for the CCPs) and adequacy being achieved through the somewhat questionable assumption that the margins taken will allow for any adverse market movement even in an extreme crisis.
The big challenge from the CCPs is that their demand for prime collateral is driven by their imperative to avoid collateral accessibility or adequacy risks and thus select the most credit worthy and liquid of collateral. Unfortunately, this does not necessarily correlate with the available collateral at their major users.
That, in turn, leads to demand for collateral swaps and other collateral transformation structures. These are useful but not the most efficient of markets. And, should FTT be actually adopted in countries such as Germany (a major source of prime collateral through the Bund market), the cost of such transactions could rise substantially. Indeed, even the granting of collateral, under current indicated FTT rules, would be subject to that intrusive tax!
An equity fund looking to hedge its exposures through futures products has, essentially, equity to offer as collateral. A bond or money market fund will have interest bearing products, mainly bonds, but they are unlikely to be predominantly prime collateral based. A prime broker may have a more distributed pool of collateral available, but once again this is rarely going to be cash or prime governments. Hence the demand for swaps or the growing demand for cash transformation of investment instruments of all types from the market. Cash, at least, is intellectually in infinite supply whilst prime bond availability is capped. The challenge on the cash side is not its technical availability, but the appetite of the banking sector to take such short term transactions on their ever constrained capital bases or of the shadow banking sector to have that capacity as regulation reduces their appetite for lower margin and short dated opportunities.
In reality, as we move along the road of the imperative for collateralised transactions, the markets are faced with some of those distinct challenges raised at SIBOS. How do they make the available pool of collateral truly liquid? How can the pool be extended? And at what point will collateral availability be a break to market activity? And will the risk appetite of the market evolve to enable more activity by more liberal application of netting across instrument types?
The ICSDs, especially, have made great strides in helping the market improve collateral liquidity. Their hub and highway solutions are a real value for the market, and are gaining traction from participants and other CSDs. But simply improving the availability of the existing pool is not enough. The pool needs to be extended and therein lies one of the big challenges. Extending the pool reduces its quality. And the quality is reduced for multiple reasons. A wider pool would reduce the average liquidity of collateral held, as equity and corporate debt is generally less liquid than cash or government bonds. A wider pool reduces credit quality. And a wider pool risks reducing the correlation between the settlement or clearing liabilities and the collateral supporting these. Theoretically, this can be managed by haircut adjustments, but that would most likely reduce the scale of extra risks rather than eliminate them, unless the haircuts are so severe they become impractical.
That points to the true choice in markets. Either the central infrastructures take on more risk or collateral availability by specific demand will limit activity. Regulators will not allow CCPs or other infrastructures the luxury of lowering their guard against risk. Some extra value may arise from the introduction of improved netting in stock lending, instrument swaps, or other similar transactions.
But, in reality, collateral is another tool for the regulators, alongside taxation and capital, to limit and counter the apparently insatiable longer term appetite for high volume trading in today’s capital markets.
John Gubert
Chairman
Global Securities Services
Executive Committee