From the desk of John Arnesen
Consulting Lead, Pierpoint Financial
Last year, I wrote a blog questioning why collateral is necessary if the rating of your counterparty is higher than yours, or more importantly, than that of your client (when acting as agent). I recognise that this is unlikely to happen; securities finance develops at a pace that seems painfully slow compared to other financial products, yet no shortage of fintech's are beavering away at the margins, about to disrupt the model as we know it forever, allegedly.
Collateral is not one of those elements that will disappear, but could the range and way it is posted change for the better?
In the 31 years I have been involved in the industry, the nature of collateral has not changed that much. The most notable change has been the decline of cash collateral, taken to reinvest in permitted assets and create a spread between the rebate (interest paid to the borrower on the cash proceeds of the loan) and the yield on the asset purchased. The global credit crisis of 2007-2009 led to a substantial decline in the use of this model, driven by a deterioration in asset prices, evaporation of liquidity and defaults of some investment structures. Despite this development, in my opinion, cash is still the purest form of collateral. It is fungible, highly liquid, and provides flexible, high-quality reinvestment options.
Since the GFC, cash collateral has taken second place to non-cash, assigned mainly to the US, where equity collateral is still a problem to post, and reinvestment opportunities are greater. The chart from Datalend describes the current state of play.
European and Asian-based lending activity is predominately non-cash collateral-based, but there is a range of how collateral settles, who is driving the decision of which asset type to post and accept, and why is the universe of collateral not more expansive?
In securities finance, collateral acceptability options are provided by agent lenders. Agents have a defined list of what is permissible that is driven by their indemnification policies. Non-cash collateral results in both the loan and collateral falling under indemnification, and the agent absorbs the cost of that provision. Assets that increase those costs will be rejected, which is entirely reasonable given what the indemnification provides to beneficial owners but can be a limiting factor.
Collateral's purpose is to provide a value against the default of a counterparty. It follows that acceptable collateral must be highly traded, benefit from a depth of two-way prices, preferably exchange-traded with relatively low volatility. In the event of default, beneficial owners need the assurance that collateral will be liquidated and the proceeds used to replace the lent securities as soon as possible. There are several moving parts to this scenario, and one of those is that all the liquidity in the world on the collateral side won't help in the efforts to replace an illiquid security, such as a small issued corporate bond, for example. But I digress.
Borrowers need to post the most expensive assets to fund and automate this allocation via triparty agents (TPA). As a beneficial owner, regardless of how liberal your acceptable collateral policy is, it will be filtered to match the collateral policy of your agents. For agents, the collateral offered will push the limit of your policy's credit and concentration aspects for good reasons. Over the years, through constant development, TPAs have become masters at optimising collateral allocation for their clients, and it's no coincidence that some banks are developing collateral services to enable them to deal with Uncleared Margin Rules (UMR). State Street, for example, are adding their tri-party service to their collateral + platform for these purposes.
So, borrowers are happy as Larry to post any form of collateral an agent needs, as long as they are long of it, don't have to buy it, and collateral needs for more discerning counterparties have already been satisfied. The ubiquitous 'collateral upgrade' trade is a perfect marriage for agents with deep sovereign debt holdings if they can accept equities or corporate debt as collateral. The borrower finances their long position while satisfying their regulatory requirements under LCR.
This transaction has produced decent revenue for beneficial owners over the past few years, although today, it requires more duration risk to generate similar fees. It only works if something other than sovereign debt is taken as collateral. The most common is index equities and corporate debt, as mentioned above. Beneficial owners that only accept highly rated government debt will lose out on this transaction, but even worse, it may affect their entire programme as such collateral is valuable to borrowers and expensive to source. If the latter is required, it will reflect in the ability to make loans of non-specials and fee generation will inevitably be lower.
A lot of securities financing boils down to something quite simple. As a borrower, how can I optimally exchange my long assets for my short assets with the highest possibility of a match? As a lender, having highly sought-after supply is only part of the story; a diversified, accommodating collateral policy is needed to mobilise that supply.
What if however, the collateral borrowers hold changes in the future for some reason or, with the growing demand for collateral due to changes to derivatives regulation, borrowers find better uses for it internally and narrow the availability to the securities financing desks?
Some years ago, I was visited by Grant Davis, who was then with JP Morgan and was handed a large bar of Toblerone. JP Morgan collateral services were celebrating the completion of a project in which they would be able to accept gold as collateral for securities finance transactions. The Toblerone represented a gold bar as they come in a gold wrapper, a universally known fact. At the time, I thought this quite innovative but was unsure which borrowers would offer it, how it would settle etc. I did establish that, to my surprise, several of our beneficial owners had no issue in accepting gold as long as the detail of the process was laid out to them. The concept of gold as collateral could be used in a variety of transactions, its popularity as an investment tends to rise and fall in line with inflation expectations. From memory, I don't believe there was much take up then, but could it make more sense now?
The rise of digitisation has the potential to tokenise almost any asset or commodity and has enormous potential in securities finance to solve for the cross-border movement of assets. The good people at HQLAx are progressing the digitisation of collateral, and no doubt, the application of tokenisation could find uses in many other areas of securities finance. And tokenisation would solve some of the logistics of gold settlement backed by some form of certification to its physical form.
At Pierpoint, we think the timing may be suitable to explore this concept further, so look out for a more detailed blog exploring the viability of gold as collateral soon.