As the regulatory gods continue to mould the global collateral landscape to their liking, the way forward remains treacherous for the securities financing industry—but innovation and an ability to adapt may yet prove to be its salvation.
Ever increasing demands for ritual sacrifices in the form of margin calls and other liquidity buffers is testing the faith of both buy- and sell-side participants, with liquidity squeezes becoming most pronounced and painful during quarter ends. In response, technology providers, vendors and trading platforms are mobilising to offer technical and logistical relief.
After years of rumours and anecdotal evidence of a regulatory-driven liquidity drought in the global capital markets, BNY Mellon and PwC set out to quantify the scale of the problems facing the market in a survey of buy-side participants. The subsequent report states: “The picture that emerged during these discussions was of a buy-side facing unique and challenging funding circumstances. One common concern shared by all respondents was the impact that the introduction of forthcoming non-cleared margin rules will play in exacerbating their liquidity stresses.”
James Cherry of Pirum Systems notes that the International Swaps and Derivatives Association estimates that encumbered collateral in support of non-centrally cleared activity alone will reach approximately $800 billion by 2020, and some estimates go to $1.7 trillion. At the same time, the Financial Stability Board’s (FSB) proposed introduction of mandatory haircut floors for repo and securities lending are expected to further drive demand.
However, there is hope. The International Capital Market Association European Repo and Collateral Council’s year-end report stated: “Dealers quickly began to scour the screens for offers in specials that were cheaper than the prevailing general collateral rates, while banks that traditionally could only take German collateral as HQLA quickly relaxed their policy in favour of other core sovereign credits”.
According to Cherry, this represents “further proof that the market can swiftly adapt to change when necessity dictates”.
The crucial part that adaption has to play was reinforced by the International Securities Lending Association (ISLA) in its seventh market report published on 30 August.
Drawing on data from its members and the three main data providers, ISLA stated: “While balance sheet reduction at key reporting dates has become a permanent feature of borrower behaviour, the recent quarter ends were completed in a more steady and orderly manner than previously observed.”
The association revealed that, after unprecedented volatility and dislocation was observed at the end of December 2016, the market better anticipated the end of June 2017 liquidity squeeze by reinvesting from the middle of the month onwards.
ISLA continued: “We also saw a willingness to recall cash collateralised loans ahead of the 30 June and return any cash collateral to the borrower, thereby avoiding any reinvestment issues over half year end. Demand to borrow government bonds remained robust during the first six months of the year.”
Know thy enemy
According to BNY Mellon, blame for causing these concerns should be laid squarely at the door of Basel III. According to the bank: “Funding stresses among US buy-side participants first appeared in 2015 as some clearing clients began to report huge increases in their OTC clearing fees from their clearing banks. These increases were so large that they effectively drove some hedge funds out of the cleared OTC derivatives market altogether in a process that the industry has come to euphemistically refer to as ‘offboarding’.”
“Both of these episodes share the same underlying cause: strongly improved bank capital and liquidity standards enacted under Basel III are mandating that dealers hold markedly more cash to meet bolstered capital requirements and highly-liquid securities to meet new liquidity ratios.”
Cherry also highlights the European Markets Infrastructure Regulation and the US Dodd-Frank Act as “massive consumers of high-quality liquid assets (HQLA) as further drains on available collateral”.
In the face of all these obstacles, it’s become a question of sink or swim.
What’s to be done?
As part of its buy-side report, BNY Mellon offers four possible solutions to the current collateral conundrum, but adds that “each of them comes with a caveat, however, likely meaning that no single solution will be sufficient to address the liquidity shortfall. What can be agreed is that technology will be at the core of whatever answer the market lands upon.”
Euronext’s Dennis Mullany says: “In response to the issue of intermediary costs, a number of ‘all-to-all’ platforms have been launched in the last two years with the aim of giving buy-side clients direct access to financing markets.”
“At Euronext, we feel that this is an important development, not because the services that banks provide in financial markets will no longer be required, but because clients need to have other options during market turmoil or when a bank’s appetite for providing that particular service diminishes.”
Bimal Kadikar of Transcend Street Solutions explains: “To fully meet these compliance deadlines within the next 12 to 24 months, most firms do not have the luxury of adopting a strategic approach to reengineer their business and technology architecture and have been forced to take tactical steps to ensure compliance.”
“However, it is likely that achieving compliance in a short timeframe will create huge business and operational overhead costs, as one-off solutions may not be tightly integrated and may require additional manual work and reconciliations over time.”
“The ongoing need for changes to front-office business processes will have an impact on compliance solutions, potentially causing firms to significantly increase the operational overhead of supporting these businesses.”
In the end, post-trade efficiencies will only get you so far and a long-term solution to the collateral problem will require fresh sources of high quality and liquid collateral to be found.
Richard Gomm of Lombard Risk reinforces this, saying: “Access to high-quality collateral positions via repo transactions coupled with competitive edge gained from technological efficiencies are vital to market liquidity and the elimination or easing of the collateral scarcity phenomenon.”
For some, the answer is the already emerging use of exchange-traded funds (ETFs) as collateral, but even here there are problems. Mullany explains: “The use as collateral of assets such as ETFs, in which volumes in Europe have been increasing steadily over the last decade, is relatively low.”
“There are a number of reasons for this, including the complex classification process for a product with such a diverse range of fund structures and asset classes.”
“Also, historically, it has been difficult to systematically see through to the underlying components of some ETFs for risk purposes, which has restricted trading volumes and in turn makes them difficult to use for financing purposes.”
The SLT Collateral Annual will be available at IMN’s 22nd European Beneficial Owners’ Securities Finance & Collateral Management Conference in London on 12 September.