By Clement Phelipeau, product manager, Derivatives and Collateral Management Services, Societe Generale Securities Services (SGSS)
It is a time for asset managers and financial institutions to make some bold decisions as they adapt their collateral and liquidity management functions to support the future growth of their global investment activities.
The combined effects of the European Market Infrastructure Regulation (EMIR), Dodd Frank Act (DFA), Basel III and the Markets in Financial Instruments Directive (MiFID) are changing the landscape of financial markets, prompting participants to adapt their strategies. Economic studies estimate that demand for high-grade collateral may rise by between US$4 trillion and US$11 trillion (Basel Committee on Banking Standards, Bank of England & ISCO-CFTC) during the next two years, principally as a result of Basel III capital requirements and margining requirements for OTC derivatives cleared via central counterparties (see below). Coping with these new requirements will create a need for firms to enhance their processing capabilities, to manage the associated costs and to refine their funding strategies.
According to the EMIR timeline, mandatory clearing for OTC derivatives in Europe will be implemented by mid-2016 for clearing members (category 1), end of 2016 for category 2 counterparties, mid-2017 for category 3 and end of 2018 for category 4. For bilateral OTC derivatives transactions, collateralisation (through posting initial margin and variation margin) will be required from September 2016. The strain thereby imposed on pools of eligible assets will start to increase in 2016.
In current economic conditions, it may seem logical to employ cash collateral to meet a major share of collateralisation needs. Interest rates are low across many EU markets and funding costs are near their historical minimum, amplified by sizeable asset purchase programmes from the European Central Bank, the US Federal Reserve, and the Bank of England in response to the 2008 global financial crisis and the more recent Eurozone crisis. As an example, in March 2015 the European Central Bank purchased €60bn of highly-rated securities through its asset purchase programme and it expects to repurchase €1140bn in securities between March 2015 and September 2016.
Significantly, many securities that are likely to be eligible for collateralisation are otherwise engaged, stored by participants in an effort to comply with the Basel III Liquidity Coverage Ratio and Net Stable Funding Ratio requirements. Even though the Basel Committee on Banking Standards has recently broadened the category of eligible assets that can be accepted, these ratios are draining a sizable amount of the pool of available high quality assets. There appears to be an immediate and easy answer to address these issues: choosing cash. Indeed, ISDA estimates in its 2014 Margin Survey that approximately 75% of collateralised exposures are currently met through use of cash collateral, 15% through Government securities and 10% through other securities such as corporate bonds and equities.
Yet, we need to look at the bigger picture. The truth is, these low interest rates and cheap funding environment will not continue indefinitely. There are already market signals demonstrating that investors are anticipating a rise in interest rates in coming months. Furthermore, firms will need to think carefully about how they meet their collateral commitments – negative rates may be applied to credit cash balances held at CCPs and there may also be a significant spread (e.g. EONIA minus 35bps for EUR credit cash balances, London Deposit Rates applied at LCH.Clearnet). Also, there is an 8% haircut on cash if the currency differs from the derivatives obligation for bilateral margining, which is much higher than the haircut applied to high-quality government bonds.
The article was originally published by Societe Generale Securities Services on: http://www.securities-services.societegenerale.com/en/viewing-collateral-management-through-new-lens/