My Thoughts on the 'Collateral Highway'

In a recent interview with Global Custodian, Tim Howell, CEO of Euroclear, coined the phrase the collateral highway. He explained how Euroclear is working with other CSDs and agent banks to increase the sources of collateral supply.

This is welcome news, for the world is fast running out of acceptable collateral. And the situation will not improve. The reality is that there is a greater likelihood of further downgrades in country credit ratings, and this could accelerate to the depletion of the current eligible collateral pool. And we have to add to this growing scarcity of collateral, the impact of the trend to secured exposures for more and more risk products, with even central banks now apparently willing to post collateral.

The important fact highlighted by Howell, though, is that we face two issues. There is a shortage of collateral and also major inefficiencies in the collateral management process.

There is very little we can do around the shortage of collateral. The trend is for interbank lending to migrate to central bank liquidity facilities and for derivatives to be forced into CCPs, both of which regard collateral and mark to market as prerequisites. It also appears inevitable that the collateral takers will ease their credit quality requirements in order to remain viable. That will create, among other things, an interesting dilemma for regulators. They have, through the CCP proposals in Dodd Frank and EMIR, created concentration risk secured by cash or near cash-quality collateral. If the collateral pool were to widen, without compensating increases in haircuts, credit quality at the high volume CCPs will degrade. No wonder the regulators are reviewing their role as possible lenders of last resort to this sector; I wouldnt want to be the politician explaining that multi-billion dollar problem to the electorate!

There is, though, much that can be done about collateral accessibility. The collateral highway points us in that direction. With the ten largest global custodians accounting for the bulk of assets in existence, their collaboration becomes vital. The problem is that they may be the technical holders of the assets, but the legal ones are spread around the world and subject to a variety of constraints (for instance, hedge fund assets may already be hypothecated to their prime broker).

So the question is not so much who controls the assets as how does one mobilize assets. Communication is key, with SWIFT being a logical network, given that it is real time, resilient and has high latency. But who is in the communication flow? Collateral management could involve the investor, the global custodian, the sub-custodian, the CSD and the collateral operator (an ICSD as a tri-party manager, as an example).

The reality is that collateral management is not custody, and efficient collateral management needs to involve a re-engineering of the business model. At the last NeMa conference, I commented in one of the panels that everyone saw collateral management as their new revenue stream; in reality, efficient collateral management needs concentration of assets even where there is a collateral highway. The highway merely increases, but not infinitely, with the universe of potential participants.

The re-engineering needed appears to depend on gaining scale, speed and discretion. Scale exists with that limited number of CSDs and major custodians controlling the bulk of assets eligible for collateral. Speed is a function of those participants ability to process in real time (hence the need for a network such as SWIFT) and to maintain the appropriate records in similar timeframes. The most difficult area is discretion, for this requires delegation from managers to at least the global custodians in a structure that is not dissimilar to outsourced stock borrowing and lending arrangements. It has the same challenge around the rules for availability, recall, collateral realization and cross-border legal certainty.

The ICSDs have a distinct advantage, as they already have huge pools of collateral and infrastructures in place, as well as operating in benign local legal environments. They are also connected to all the major global custodians. Some of the largest agent banks have pools of assets but little direct connectivity with their peers.

The collateral highway is feasible; it could indeed enable greater accessibility. It just needs more courageous investors in a time of crisis to enter the collateral management fray and mandate their agents accordingly. My suspicion is that many will demand a better risk return ratio before doing so.