COLLATERAL VALUES MATTER.
Robert Almanas* tells Best Execution of the frightening prospect that in today’s market, over a third of financial institutions are willing to accept collateral simply because it is cheap, and why a shift in thinking is needed to avoid a re-run of past mistakes.
In the wake of the 2007/08 financial crisis, the financial services industry has been hit with a swathe of regulations, designed to restore order to the markets and return financial stability. Dodd-Frank, EMIR and Basel III are three of the most prominent regulations to have been imposed – bringing with them greater demands for collateral.
The central clearing of OTC derivatives under Dodd-Frank and EMIR calls for contracts to be collateralised and for higher liquidity buffers to be put in place. Combine this with higher capital requirements and the Liquidity Coverage Ratio under Basel III, and the current regulatory environment is leading to an effective collateral lockdown. As higher quality collateral becomes scarcer, the cost of obtaining it is likely to increase.
In the recent SIX Securities Services study ‘Collateral Management: How Collateral Values Can Prevent The Next Crisis’ 60 financial institutions from Europe, France and Germany predicted that high-grade collateral will increase in cost by around 9% before 2015. This would place increasing pressure on the industry and could lead to some institutions and collateral management providers to compromise on the quality of collateral they are willing to accept. Should this happen, the industry could face a race to the bottom.
In the face of potential consequences of this shift, we argue that the future success of the financial markets hinges on a set of fundamental ‘Collateral Values’. Collateral must be simple, of high-quality, liquid, and easy to value. These principles will be key to underpinning market stability. A failure to adhere to them would mean a return to the mistakes of the past.
Cost should never trump quality
While concerns over cost will always play an important factor in collateral management, it should surely never be the deciding factor. Our study therefore makes for worrying reading with over half of institutions stating that the cost of collateral is more important than quality, and one in three institutions willing to accept collateral that is complex, low quality and opaque so long as it is cheap.
The impetus behind this willingness to accept lower grade collateral has come in part from the fear that a collateral crunch or collateral ‘shortfall’ could be dangerously imminent. The estimated size of this shortfall is widely debated, with figures ranging from billions to several trillions of dollars. This lack of certainty in the industry makes planning a serious headache for institutions.
In the race to find collateral some institutions and collateral management providers may turn to the repackaging of lower quality, existing securities to create new collateral pools. The Fitch Ratings agency in May – based on data from the Federal Reserve Bank of New York – revealed that of the $300 billion of non-government securities used as collateral for repo trades, $76 billion came from structured finance products, while $44 billion comprised collateralised debt obligations, municipals, and whole loans.
Whilst falling back on repackaged securities for collateral might be an attractive route, it is one to be wary of. The repackaging of existing portfolios and securitisation to create new collateral pools were both identified by almost of half of the participants in the survey as a source of additional risk that could sow the seeds for the next financial crisis. Part of the shock to the financial system in the previous crisis was that repackaged securities were difficult to understand and value, with some having not been valued for long periods of time. Complex securitisation practices make it difficult for financial institutions and CCPs to gauge obligations to counterparties. On the other hand, simple collateral streamlines internal operations and provides transparency to the institutions and markets – making it a much safer road to take.
Virtualised collateral pools
Rather than diluting what constitutes acceptable collateral, we must look to effectively mobilise what collateral exists. Collateral is currently fragmented across different locations, time zones and currencies. The creation of a virtual collateral pool across markets will eliminate the inefficiencies which come from having to transfer securities across different systems.
From our own experience, it is seldom cost that is the biggest hurdle to an institution improving their collateral management processes. Many firms choose to adopt a tri-party collateral management system as opposed to a bi-lateral one for these reasons. Under a tri-party system, a third-party collateral management provider administers exposures and collateralises them using assets of the same value.
This allows institutions to access a central pool of collateral from market participants all over the world for which users pay a fee. In our survey, the majority of institutions using a tri-party system say that it offers reduced risk and ease of use from automation of processes. Tri-party collateral systems can also reduce overall costs as the institutions spend less time internally on collateral management.
Collateral for a safer financial system
Collateral management is no longer simply about maintaining efficiencies but also about ensuring that the financial system is safer than in the past. The collateral transformation route may well be a popular one, but regulators and CCPs must resist the temptation to make low quality collateral acceptable. CCPs need to remain bulwarks of stability if they are to reduce systemic risk rather than move it elsewhere.
By accepting only simple, liquid, easy-to-value and high-quality collateral, the industry can protect itself from further crises. With this in mind, the market is demanding automated collateral management solutions which not only lower costs but also enable firms to source the best collateral. Those firms which equip themselves with multi-currency, multi-asset class and multi-time zone collateral management services that can operate in real time stand the best chance of success. n
*Robert Almanas is managing director for international services, SIX Securities Services.©Best Execution 2013