From the desk of Roy Zimmerhansl
Practice Lead, Pierpoint Financial Consulting
I’m writing this blog as something of a follow-up to Raymond Blokland’s article last week on collateral management but focusing on the buy-side and continuing a recurring theme across several of our blog posts.
Almost a decade ago FT Alphaville quoted my blog prediction that “If you are in the securities finance business in any way, collateral will become a bigger (and more expensive) part of your life going forward.” Looking back, the definition of those involved in securities finance has clearly expanded to include most institutional investors.
During the intervening period, we have seen a huge number of changes in the operating environment for buy-side market participants that have affected the collateral management space. Several factors including increased institutional usage of listed derivatives, regulatory-driven mandatory clearing for unlisted derivatives and other bilateral collateralisation of counterparty exposures have created an environment which implicitly places collateral as a critical consideration for all market participants.
Of course, collateral-takers typically want collateral that they can dispose of quickly, easily and with the least impact on execution prices. Sovereign bonds are the favourite choice and amongst these, US treasuries and German Bunds are at the top of the list as the most desirable assets. The process requires calculation of exposures, sourcing of collateral and delivery to the counterparty/clearing broker. Investors often choose agents to operate the actual securities movements while retaining the exposure calculation.
In fact, sourcing assets can itself represents a challenge for many. Where investors run global, balanced portfolios across equities and fixed income, getting satisfactory collateral is relatively straightforward. Other investors with more focused mandates may have difficulty sourcing the necessary collateral and increasingly will need to rely on securities lending to obtain appropriate collateral. In his most recent “Reflections of the CEO”, Andy Dyson, CEO of ISLA refers to the increasingly important role securities lending plays in the mobilisation of qualifying collateral from holders to those that need it. The past decade has seen the emergence of large-scale High-Quality Liquid Asset (HQLA) lending as a critical driver of securities lending balances and revenues.
So, we have more collateralisation needs and more collateral available for loan to meet those needs. Simply put – increased demand meets increased supply. These offsetting factors suggest growing market activity in an environment of equilibrium and indeed that is what we have seen. Indeed, the collateral shortage that was promoted with some hysteria several years ago never materialised and HQLA borrowing costs have generally traded within a relatively narrow range. The key variable on rates has typically been tenure of transaction rather than supply/demand imbalances. Sounds like all is good and we are well-positioned for increasing future collateral demands. I’m not so convinced.
My observation is that each of the collateral need drivers have traditionally been addressed in isolation by buy-side investors. What I mean is that as each business need has arisen, clients have addressed their immediate requirements without considering other existing or future collateral needs. Sometimes this has resulted in a less than optimal operating environment. It is not uncommon to see large portions of HQLA ring-fenced as available collateral for margin calls. These assets are essentially “dead” while waiting for a call which may never come and when it does, is only for a portion of the portfolio. Further, where receiving collateral from counterparties, these assets are also static, held pending a return of excess collateral. Almost by definition, these assets are also held outside of lending programmes.
Yet those securities lending programmes are designed for same-day return or substitution of loaned assets and with a re-examination of the various collateral activities, both receiving and giving, surely there is scope for integration of activities and mobilisation with less friction. Collateral optimisation for the buy-side can often be enhanced by restructuring existing activities without necessarily the need for new technology. A full revamp with an aggressive, alpha-generation reorientation might be desirable for some, but of course that is another story and not one I’m looking at here.
Operational savings and/or incremental earnings are available today for many investors.
As more buy-side firms are captured by Uncleared Margin Rules and bilateral collateralised transactions outside of derivative activity continue to grow, today’s inefficiencies will become more widespread and pronounced, eventually having some market impact.
This reality is also playing out as investors and banks look to expand the universe of available assets. People have been trying to find ways to use money market funds as collateral for many years with limited success but gathering momentum. Given that there is approximately $2.4 trillion in USD government money market funds, the focus is hardly surprising. Additionally, one of Pierpoint’s earliest assignments was to assist a client in developing an alternative to money market funds that had similar return and liquidity characteristics, but in transferable security form so it could also be used as collateral for derivative, repo, securities lending and other bilateral collateral needs. That instrument will be issued early in 2020 and represents one of the innovations that will improve collateral markets. Finally, finding ways to get value from illiquid assets is a topic for a future post.
As we move into what we expect to be the final implementation phase of the key post-GFC regulatory changes, the economics for greater collateral integration for the buy-side are there for the taking. The longer it takes investors to seize on the potential, the greater the disruption when they finally do, and the larger the opportunity cost of any delay.