It’s an axiom among market participants that, since the global financial crisis, regulators have consistently underestimated the liquidity-draining and capital-consuming impact of tighter – and pro-cyclical – macro-prudential regulation. There is, perhaps, no greater example of the unintended consequences triggered by new regulation than the dark clouds looming over the collateral management industry. New rules governing the derivatives market, tighter capital and liquidity rules, combined with shifting industry practices – leading to increased demand for perceived safe assets – have all reduced the supply and velocity of global collateral.
This new regulatory and risk-management environment is making high-quality collateral scarce for derivatives participants, while the US Federal Reserve’s quantitative easing cycle has taken more than $2.5 trillion out of circulation from the US’s $11 trillion US treasuries market.
This scarcity of collateral has had a profound impact, during the past year especially, on G7 monetary policy and sovereign risk, as well as the price and supply of credit. The fear is that a further tightening in regulation and industry practices will exacerbate this problem further.
Andrew White, general manager of settlement services at the Australian Securities Exchange in Sydney, says: “Regulatory change now requires banks and financial institutions to have significantly higher levels of collateral to back their transactions, for example to manage counterparty credit risk on derivatives transactions. This means that the availability of high-quality collateral will become an issue that simply wasn’t there five years ago.”
With participants facing increased demands for high-quality collateral to play in the Dodd-Frank-era derivatives market, market structures are adapting to cope with the shortage.
European securities settlement houses are offering sophisticated ways for their clients to monitor, manage and access collateral stored in different custody systems around the world.
The latest solutions allow central securities depositories (CSDs) to manage both domestic and cross-border collateral transactions while reducing counterparty risk by, for instance, allowing customers to store collateral locally in their own custody systems on the accounts of the underlying customers, rather than moving them to the settlement houses’ account.
“Many financial institutions have assets held in a number of departments, even at individual desks, and have no overview of how much they have and where it is,” says a Clearstream spokesperson. “They may have assets which could be eligible for collateral use held across a number of platforms and locations throughout the world, with no single overview.”
A study carried out by Accenture for Clearstream two years ago showed that collateral fragmentation cost global institutions €4 billion in lost collateral value per year.
At the same time, central security depositories in Australia, Brazil, Spain and South Africa are taking steps to improve transparency by sharing information and management techniques between jurisdictions.
The Liquidity Alliance hopes that better information will allow collateral markets to operate more efficiently during times of market stress, speeding up the flow of collateral around the financial system.
“The Liquidity Alliance brings together CSDs, with the aim of exchanging information and identifying common needs, while encouraging research, ideas and opinions,” says White. “The Liquidity Alliance believes that information-sharing partnerships are essential to finding effective global solutions in the collateral space.”
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| Manmohan Singh, Senior |
It’s the speed of collateral through the financial system, or its velocity, that concerns IMF senior economist Manmohan Singh, whose work on the role of collateral in the shadow banking system has catalyzed the regulatory debate in recent years. Singh notes that before initiatives such as the Target2 Securities settlement system, collateral posted to a security depository was effectively siloed. “The management systems offered by the settlement banks allow their clients to move collateral out of national siloes, increasing its velocity,” he says.
While European custodians benefit from integration initiatives – such as the European Central Bank’s Target2 Securities settlement engine, which allows them to settle local currency securities through one centralized system – US players face substantial challenges, says Singh. “The big US custodians do not benefit from the same level of connectivity offered by the Target2 system, plus regulations may be forthcoming that reduce the overall level of tri-party repo activity, which would make collateral more scarce,” he says.
With global regulators focused on risk reduction through collateralization and centralized trading venues, the demand for high-quality assets seems only set to increase during the next few years as new capital rules are phased in.
Industry estimates suggest derivatives participants will need between $500 billion and $2.6 trillion of additional capital under new rules. Already a big part of the collateral management industry, collateral transformation is emerging as a growth area for banks and custodians seeking revenue opportunities amid the new regulatory landscape.
“Banks are skilled in collateral management but it’s not clear how much collateral transformation should be encouraged,” says Singh. “We need more clarity on how these transactions affect risk-weighted asset ratios, and what actually happens to a bank’s credit risk when it turns a triple-B rated asset into a double-A. Wall Street has a poor historical record when it comes to asset transformation.”
Even with the Basel Committee’s dilution of the liquidity coverage ratio – freeing up more global collateral – the collateral management industry will be faced with a surge in demand and a reduction in supply of assets needed to oil the wheels of global finance. The hope is that more flexible regulation and new market structures will help to temper this challenge for the global financial system.
However, few are holding their breath, especially as the run-up to and aftermath of the global credit crisis threw into sharp relief the insatiable impulse of financial markets to chase perceived safe assets.
In the meantime, the shortage of collateral threatens to distort asset prices and misprice risk by artificially depressing yields on high-rated collateral-eligible sovereign debt.