Nerin Demir, Head of SIX Repo Ltd & Securities Finance at SIX Securities Services
In the aftermath of the financial crisis, collateralisation has become the industry-accepted way to conservatively – and actively – manage risk. The impact of credit risk exposure on balance sheets is significantly reduced by pledging high-quality liquid assets (HQLA) that can be easily and immediately converted into cash in private markets. However, the advent of new technologies, increased competition in the institutional finance industry, and heightened counterparty risk, mean that collateral management has become an increasingly complex consideration.
Some estimates suggest that due to new banking and safety rules, firms will be required to hold a greater proportion of cash and HQLA, creating a demand for $2-4 trillion worth of additional collateral. With this in mind, institutions’ ability to optimise collateral is now in the spotlight – particularly when it comes to collateral mobility, and the ability to effectively source and pool collateral. Many will not have the required eligible asset types (predominantly cash or government bonds) or if they do, they may hold them in a different legal entity or geographical location. These are then considered to be “trapped assets”. The goal is to minimise the shortage of collateral resulting from fragmentation, enabling the collateral giver to move the required assets across borders. This is important, allowing the funds to be directed to the right place, at the right time, to cover the right exposure, as well as keeping operational and regulatory costs to a manageable level.
New global regulatory requirements (such as Basel III, MIFIR – The Markets in Financial Investments Regulation –and the Central Securities Depository Regulation) are currently forcing parties in the financial value chain to look differently at how they collateralise their counterparty exposures. ISSA has just published its Second Report on Collateral Management – Cross Border Mobilisation of Collateral – highlighting legal collateral structures and recommendations for industry best practices. With many different parties involved, including hedge funds, broker dealers, securities lending agents, trade repositories and custodian banks, the benefits and potential risks of each model must be weighed up carefully. This selection process will depend on a number of factors, including the current and future business models of the selecting institution, the variety and diversification of asset type to be used as collateral, and serving level requirements. Institutions must ask themselves whether they are looking for a fully outsourced collateral serving model, or whether it would prefer to retain a high level of operational involvement in selection and mobilisation of collateral to meet requirements.
Whilst it might seem contradictory, many of the same regulatory initiatives that are driving the need for collateral mobility are creating barriers to the smooth and efficient flow of collateral on a cross border basis. These include account structures (specifically account segregation, designed to provide greater asset protection for individual investors, compared to omnibus accounts), harmonisation initiatives and collateral liquidity – it is crucial that the industry is able to scenario-plan for stress conditions that would be caused by a significant market player default, or changes to interest rates.
Whether an organisation is well versed in collateral, or new to the space, it will need to evaluate whether the existing or new models that are available will fulfill their needs. To do this, they must look within their organisation to assess their investment strategy and associated risk exposures, to determine whether they have a collateral mobility requirement. Only then can they turn to the wider market and question collateral mobility services and determine which model and organisation would best suit their needs. The ISSA report provides an outline of questions, to serve as a guideline for those starting out on this journey.
Much has been written about collateral supply and demand, with a strong focus on the possibility of a collateral shortage. This debate continues, though has become more nuanced as institutions grapple to ensure that available collateral is being used efficiently, and with maximum impact.