Updated: Jul 17, 2020
From the desk of Raymond Blokland
Benelux Consulting Lead, Pierpoint Financial Consulting
Very soon after the 2008 financial crisis and the collapse of Lehman Brothers, there came a huge focus on collateral. Collateral has always been a key element of the financial markets but not necessarily in a regulated manner. It was basically up to companies themselves to decide on collateral criteria such as eligibility, haircuts, timing, margins, etc.
Securities lending is a good example. It is still today in majority a business whose legal framework is bilateral and whereby both parties have the freedom to negotiate their agreements as they see fit. Flexibility on collateral is therefore still a differentiator that can be utilised by the buy-side if it seeks to increase revenues.
However, one the of the (bad) outcomes of the crisis was that parties had accepted collateral that could not easily be liquidated when stock markets collapsed and money markets had temporarily seized up.
Subsequently banks needed to clean up their balance sheets due to new regulations and this led to a huge demand for easy-to-liquidate collateral, particularly High-Quality Liquid Assets (HQLA), and as a result a staggering increase in trading volumes concerning the famous collateral upgrade trade. That is, upgrade for the borrowers but increased credit and market risk for the lenders, or their agent (who indemnify against borrower default). These increased risks are manageable but lenders need to be aware of them as there is no such thing as a free lunch.
In the “old days” (prior to 2008) obviously collateral trading was not a big revenue generator. Equity lending was. In that period, collateral management was usually a back-office function and its more advanced brother, collateral finance, a mid- or front-office one. The lending and borrowing of equities was (and is) well organised within the infrastructure, with functions such as inventory management, position ladders, exposure reporting and interfacing to a large variety of providers such as tri-party collateral agents. Funnily enough, collateral finance was quite often managed by the famous securities finance system: Excel.
Many vendors of systems have jumped on the bandwagon and want to provide organisations not only with proper inventory management of their collateral, but also bringing that inventory together at the highest possible corporate level. This quote from a vendor says it all, I guess:
“the ability to break down product silos and provide a holistic, cross-product view of risk to optimise firm-wide collateral inventories gives rise to competitive advantages which are not only proving to be critical to the success of any institution but for the financial industry as a whole.” A wonderful (but not very modest) sentence and with the use of the English language that I, as a simple Dutch guy can only be jealous of…
I can see the rationale for it, but it is in my view mostly applicable for sell-side firms and even then, it can be a challenging objective. That being said, securities finance (and prime brokerage) is an activity that has aimed to be self-funding for decades, so utilising what is “in the box” has always been the name of the game, and securities finance is usually at the centre of firmwide balance sheet management, so how suboptimal is it all anyway? And then, let’s not forget the internal politics within organisations. Every business unit has its own management and P&L and is probably very happy with their own part of the balance sheet. I doubt if they are very willing to give that up for the greater good of the company. Let’s not be naïve about that.
On the buy side, the problem is less important as a fund will lend its assets and receives collateral. In the case of non-cash, it will simply sit on the collateral. In the case of cash, it needs to reinvest that cash. By the way, I personally never really liked that cash collateral option since the reinvestment will increase the economic exposure of the fund and will create leverage, often not permitted in the investment guidelines. But this is a subject for another blog.
Will the Uncleared Margin Rules (UMR) change all of this? To be honest, I have my doubts. UMR is in essence not so different from the old structure of “ISDA + CSA” – the Master Agreement published by the International Swaps and Derivatives Association (ISDA) plus the Credit Support Annex (CSA). And with those bilateral agreements, daily margining with performance triggers could also be negotiated. The process of dealing with the CSA obligations should therefore already be in place with every party that signs an ISDA.
That leaves us with the question of having enough or the correct type of collateral. The sell side is traditionally geared up well to find the right type of collateral for each situation, whether it be UMR or otherwise.
How about the buy-side? As I wrote earlier, a typical traditional long-only fund’s guidelines usually do not permit leverage. So, if it holds a position in OTC derivatives, it could very well be cash long in the underlying market value of that derivative position, and it can therefore quite easily fulfill its Initial and Variation Margin obligations. Besides that, the eligible collateral criteria concerning UMR are quite flexible which means that the long inventory of the fund often can also be used. Maybe funds that invest in very exotic markets or products can have difficulties in using their long inventory as collateral, because these assets do not meet the UMR-eligible collateral criteria. For these types of funds, a centralised collateral pool might be the solution. But what can be pooled together then? Most funds are separate legal entities, and you cannot simply have the long holdings of fund A be used as collateral for the OTC derivative positions of fund B. Again, more on this in a future blog.
So, my conclusion for now is that centralised collateral pooling and management sounds great as the only efficient way forward. The reality at the moment is unfortunately, not so clear cut.