Some years ago, as the challenges of the Alternative Investment Fund Managers Directive (AIFMD) for our industry became ever more apparent, there were dire warnings of the need for material price increases to cover the increased risks being assumed. And, at the same time, treasurers of the major banks worried about the twin dangers of rising demand for liquidity and an apparently insatiable appetite for prime collateral as they contemplated Dodd-Frank, European Market Infrastructure Regulation (EMIR) and Basel III.
Yet, in reality, prices have continued to head south. Liquidity is still treated as a “free” gift or, at the most, a plentiful resource. And collateral shortages are being more talked about than experienced. So how did everyone get it so wrong? Or were they just talking their book? Or is the storm still to come?
The reason prices continue to head south is a factor of the structural overcapacity in the custody market. The reality is that capacity is increasing at custodians as they automate and markets progress. The technology platforms of most custodians are being upgraded and this upgrade is driven by two core facts. First, the old technologies on heavy-duty mainframes are well passed their sell-by date. Many are in dying computer languages and, more importantly, on legacy platforms that will eventually cease to be supported by their vendors. Second, the modern market demands a more flexible and modular environment than the past. Internal co-hosting of platform between investment bank and custodian arms, the extension of product with more investment classes and the growing need for wider market access has changed the IT architectural landscape beyond recognition. As well as increased capacity, we have changing dynamics in the market, many reducing demand just as the supply side grows. The emergence of more central counterparties (CCPs), the migration of former OTC instruments onto traded markets and improvements in straight-through processing (STP) rates with the richer messages in ISO 15022 and ISO 20022 have all reduced demand. And there has, at the same time, been a trend toward market harmonization, especially in the EU, for that has been one of the by-products of TARGET2-Securities (T2S), although it was already foreshadowed in the powerful Giovannini report. In this environment, price increases, even with increased risk absorption, is a difficult challenge!
One of the mechanisms that many view as a compensating factor for such a perverse pricing environment is the advent of new products around liquidity and collateral. And the commingling of treasury and custody, either in an organizational hierarchy or through dedicated prime service outlets, is at the core of this trend. It should be noted that this structural change in the market may prove costly if ever there is a conflict between the fiduciary role of the custodian and the principal or de facto principal role of the treasury or prime services operation. However, that is perhaps the substance of litigation to come and will join the unhappy queue of experiences around alleged foreign exchange gouging or inappropriate stock lending cash collateral redeployment. Custodians now talk, with their experts usually in tow, of derivative execution and clearing, collateral switches or optimization, and liquidity management.
Collateral management is a hugely different animal from the relatively unsophisticated vehicles we had just a decade ago. The ICSDs have created valuable hubs and highways as well as putative alliances cross-border that could internationalize collateral management. And governments have been incredibly helpful as they have extended the stock of prime or close to prime collateral as a result of their budget deficit financing programs. However, I would expect this surfeit of prime collateral to be a short-lived state of affairs and would argue that the paranoia for collateralization will lead to two unfortunate trends and two major potential fault lines in the markets. The two trends are simple. Supply will decrease as governments bring their deficits down to more normal levels and, indeed, even start repaying some of their historic debt. And demand will grow exponentially, with the need, from new facilities such as T2S and the new CCP environments. And the regulators are likely to view the international securities markets and their commercial bank settlement process as fair game to bring into the central bank money fold, both for risk reasons and also, perhaps in the EU, to feed volume over the T2S platform. The fault lines relate to the structure of the markets and the risk-averse nature of much of the supply side.
The current demand for collateral from the key takers is for high-quality governments and cash and that often fails to match the natural inventories of their counterparties. Hence we have collateral swap markets and repo, tri-party and other facilities. To the extent that this market can accommodate demand, the pressure remains tolerable, but, with reduced issuance and increased usage, it is logical to expect a future shortfall of available collateral against demand despite the enhanced facilities and extended reach of major intermediary entities such as the international central securities depositories (ICSDs). And we need to add to this the fact that a large part of the collateral supply chain is highly conservative. They may accept the legal certainty of the different collateral management arrangements in normal times, but can we be sure that they will continue to accept counterparties in times of crisis? Will a major central bank or pension fund be sure of the collateral mark-to-market security at times of market slump and the inevitable rumor mill that will surround it? Or will they eschew the odd basis point or so on a billion dollar exposure to avoid such a risk? Market availability can dry up instantly and rumor of just one major institution calling in its collateral would bring chaos to markets and really test the theory as to who is the lender of last resort.
And we have a similar environment in the liquidity world. Demand is growing and supply contracting as banks shed excess assets to meet the strictures of Basel III. The move to ever greater usage of central bank money in settlement will inevitably lead to a shortage in supply, especially at times when activity in non-government securities peaks. Currently, liquidity for the bulk of the market can be categorized as free or a de minimis part of the settlement cost. I have long argued that the cost of liquidity should be the differential between the overnight and three month rate to reflect the logical funding vehicles of a bank that needs to manufacture liquidity. To that, of course, needs to be added a risk margin. Herein lies the challenge. Technically liquidity is an at-bank option intraday facility. In practice it is a medium-term arrangement, which is only withdrawn in the most extreme circumstances. But regulators are aware of this, and there is a growing risk that secure facilities will be needed to match liquidity needs of investors in the future and, more importantly, high frequency and principal traders. Although the risk appetite for many of the former is likely to be substantial, the chances are that it is substantially less for the latter population. Liquidity, rather than collateral availability, could well be the major threat to markets in the future. For, committed lines are costly, capital intensive, on a totally different risk dimension (perhaps incorrectly for they have remarkably similar risk profiles) to current on-demand facilities, and supply will never equal current demand, even if there is, as appears inevitable, an easing of central bank collateral requirements.
The future looks risky just as the regulators embrace central bank money and collateral as the panacea for the future. For, in those two structures, lies risks that may well be the driver for those cost increases that AIFMD et al. have failed to produce. And, at the same time, supply rather than demand may well drive market activity!
The Threat of Hard Times to Come
Some years ago, as the challenges of the Alternative Investment Fund Managers Directive (AIFMD) for our industry became ever more apparent, there were dire warnings of the need for material price increases to cover the increased risks being assumed.