Clearing reform in the over-the-counter (OTC) derivatives markets will not reduce systemic risk, according to 50% of market participants surveyed at a recent industry gathering at University College London. Of the 34 leading firms represented in the collateral-optimization debate – which drew together central clearing counterparties, custodians, consultants and many of the biggest banks in the derivatives markets – only 44% thought that regulatory changes, including the Dodd-Frank Act in the US and new European market infrastructure regulation, will achieve their intended effect of making the financial system safer.
It’s a discouraging conclusion from industry leaders. Derivatives reform was designed to offer them a clear bargain: reform might reduce margins, especially for the better-rated banks that dominate trading volumes in the derivatives markets, but by making the whole system safer it should bring a compensating benefit and the prospect of higher volumes of client business.
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| “MF Global showed trades don’t have to be centrally cleared to be safe” -David Field, Rule Financial |
That’s not how it looks to those working at the coalface, apparently, where the costs of overhauling banks’ collateral-management systems are so hefty that the share of a handful of leading dealing firms might even rise, so increasing the financial system’s potential vulnerability to the collapse of a small handful of counterparties. At first sight it seems odd that industry leaders should be so downbeat, given the orderly unwind of so many trades when MF Global collapsed. “The good news from MF Global was that it showed trades don’t have to be centrally cleared to be safe,” says David Field executive director of consultancy firm Rule Financial. “The vast majority of its trades were bilateral and collateralized and unwound without hitch.”
The industry’s difficulty stems largely from the operational challenge of overhauling their collateral-management systems to respond to daily and intra-day calls from central clearing parties, while also potentially organizing such responses on behalf of clients, while also managing collateral to be posted and required from other counterparties on a bilateral basis.
“Banks are being forced to offer client clearing to protect their franchise, or they risk being disintermediated – clients will simply go elsewhere,” says Field. “The concept of legally separated, operationally commingled, (LSOC), accounts will increase flexibility while decreasing costs. But we’re hearing push back from the buy-side who are nervous about commingling, so the jury is out on its future uptake. Many banks have still not worked out how they are going to charge their trading desks, let alone their clients, for the true cost of collateral, which in future will include use of the bank’s balance sheet.”
The headache in all this is that big banks do not have particularly good systems for managing either their own overall risk exposures or counterparty credit exposures on firm-wide basis, and matching those exposures against collateral to be demanded or posted. Most banks still operate several collateral-management systems that grew up within individual business units at a time when their own collateral was generally abundant compared to demands for it. All that has now changed. Collateral is suddenly precious, scarce and much in demand, including for banks’ daily funding and liquidity needs.
The IMF drew attention to this in a paper by economist Manmohan Singh published last month. “Post-Lehman, there has been a significant decline in the source collateral for the large dealers that specialize in intermediating pledgeable collateral. Since collateral can be reused, the overall effect (i.e. reduced source of collateral times the velocity of collateral) might have been a $4-5 trillion reduction in collateral.” Singh concludes: “This decline in financial lubrication likely has impact on the conduct of global monetary policy.”
Banks, meanwhile, have even more immediate concerns.
“The days when banks could fund themselves in the money markets on an uncollateralized basis are gone,” says David Little, director of strategy and business development for securities finance and collateral management at Calypso Technology, a financial IT firm. “A lot of banks’ funding is with central banks, which has to be collateralized while regulators have also required banks to set aside larger buffers of unencumbered high-quality, liquid collateral. The old management of collateral inside business silos was predicated on there being enough to go round. Now there isn’t. And banks must manage collateral much more intensively and in an integrated way.”
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| “The days when banks could fund themselves in the money markets on an uncollateralized basis are gone” -David Little, Calypso Technology |
This sounds like a given. However, it’s not easy and the industry struggles to explain why. “There’s no one reason why even the big banks found it harder than they thought to build solutions, rather an accumulation of reasons,” says Little. “There is a huge amount of data on different classes of collateral held across many divisions often subject to varying legal documents, and credit support agreements, that all needs to be brought together. There are collateral performance and valuation issues, and banks will have to require collateral from customers they didn’t previously demand it from, because the capital cost from taking the counterparty risk of not demanding collateral would be punitive.” Good systems to cope with all this will have to be capable of calculating haircuts on all manner of collateral, including lower-quality collateral, as banks look across their available inventory and seek to wring advantages from identifying cheapest-to-deliver collateral against their various legal requirements. They will also have to provide a transparent basis for charging customers to collateralize their trades.
At a time when banks are struggling to fund themselves and stay in business, and earnings in corporate and investment banking divisions are collapsing, building such systems is an expensive headache. Some of the biggest banks are spending $40 million a year today on collateral-management infrastructure and are still only in the early stages of multi-year investment projects. Those that stick with it might eventually reap the benefits in higher volumes. Many more banks will likely decide the investment is not worth it and so leave the financial system exposed to dependence on a few large derivatives trading counterparts: the very problem that derivatives regulation was supposed to tackle.
