Richard Déroulède
Societe Generale

Societe Generale’s Richard Déroulède discusses the collateral shortage, arguing there is no need to get carried away with the idea of a lack of liquidity

What trends are you observing in the equity finance market in 2016?

We see volume increasing throughout the whole equity market, including physical products such as securities lending and repo transactions, as well as synthetics products, such as total return swaps and futures.

At the same time, we’re also seeing a growth in the volume of securities lending transactions collateralised with non-cash. This trend is driven primarily by the fact that lenders are trying to reduce the amount of cash collateral they have on their books, because it’s too costly to reinvest it in the current environment.

Banks also want to avoid doing transactions with cash when possible because it impacts on the leverage ratio. Generally speaking, banks will only want excess cash on their books to finance clients, not to build liquidity.

Liquidity can easily be borrowed through collateral exchange transactions, such as borrowing government bonds in exchange for equities. This method is much more efficient than simply borrowing cash, again, due to the leverage ratio.

From Societe Generale’s perspective, we have seen growth in both the volume of trades and the average value of those trades.

Another major trend is that transactions are becoming more complex, which is driven by a variety of reason. First, banks must now manage a business that includes several asset classes. In the past there used to be a clear distinction between fixed income, where the repo desk trades fixed income assets versus cash on one side, and on the other the equity finance traders were dealing in equity versus cash.

Today, with all the collateral exchange transactions taking place traders must now understand both markets. This means they need a clear picture of two very different markets and be able to operate in both of them simultaneously.

Complexity is also growing because traders must operat on several different maturity timeframes at once. Only 10 years ago you might only be trading on open transactions but now the needs of our counterparties have evolved and they need more long-term liquidity to hedge. Liquidity exposure now needs to be balanced between open, fixed maturity and evergreen within your book.

We are also seeing growth in the synthetics market thanks to the advantage of getting transactions off balance sheet as long as you can get a counterparty to refinance the position.

How does a bank go about tackling these challenges?

Managing all these complexities in a safe and industrial way for the bank is a major challenge. The first way to start this is with accurate and careful reporting of risks into the different systems of the bank, making sure that with each transaction we understand exactly what the implied risk and the liquidity risk really is. This calculation then needs to feed into a wider conclusion about the overall liquidity risk of the whole portfolio book.

In addition, it’s vital to understand and factor in the risk of a shortage in high-quality liquid assets (HQLAs) that are essential to the day-to-day running of the market. This risk must be manage continuously at the bank level and the requires significant back-office investment.

Banks must be ready to invest to be able to know their maximum risk. Typically, you’re lending assets and receiving a wide range of collateral in return. Most banking systems will only be able to provide an overview of what a bank is receiving as collateral, but that’s not your true risk. To properly assess true exposure a bank must analyse the most liquid asset in its collateral field, which is a totally different story and requires a very different risk analysis tool.

Why is synthetic finance increasing in prominence?

The primary driver behind the growth in synthetics is the leverage ratio. However, the net stable funding ratio (NSFR) is a major threat to the future of synthetics business. When you’re synthetically financing a client you’re buying assets versus a derivative, the maturity of which is not taken into account, which is a difference between physical trades.

This means that when you’re creating a synthetic position you’re automatically creating a liquidity cap. Depending on the cash equivalent of the asset, this cap can be particularly costly if you can’t refinance. If refinancing isn’t possible, the NSFR is a big problem.

To assess the future of synthetics, the market must first wait for the final text of the NSFR to understand any exemptions that may exist.

Another challenge for synthetics is that, in my opinion, you cannot exclusively run a synthetics business when doing equity financing. Physical and synthetic business must be run together, simultaneously, in order to diversify risk across platforms and manage liquidity and capital regulations. There is no magic product that ticks all the boxes, so your book must contain several.

It’s also vital to be able to switch from physical to synthetic products, and visa versa, efficiently when managing liquidity. If you’re unable to refinance a synthetic position on the same day you must have physical products that can refinance it until you find a suitable counterparty, which could take days or even weeks.

How concerned are you about any HQLA shortage seriously affecting your business?

The idea of a bank not being able to meet its requirements because it cannot find government bonds and cannot transform cash into bonds is certainly a risk but, compared to all the other risks and challenges the industry is facing, a liquidity shortage is a manageable one, for the moment.

For me personally, making sure that I’m able to effectively stress test my books on a daily basis to ensure I have a clear view of my risks is a much more immediate and important challenge to manage.

However, we are already seeing some seasonal periods where there is a collateral shortage. For example, the second quarter of the year is tricky because there is a lot movement among market counterparts and so dealing with collateral velocity can be difficult.

A collateral shortage should not be thought of as a one-off event that could occur any day and take everyone by surprise. It happens occasionally now and all it means is you have to pay a little more for assets, but once you have accepted that, the shortage is subdued.

The situation is manageable now, but will further regulation create more market tension?

There is certainly a big question mark remaining on what the impact of further regulation will be on collateral. There is the European Market Infrastructure Regulation (EMIR), which is definitely increasing the number of assets being posted when trading over-the-counter derivatives. Banks must post collateral that is segregated and each counterpart will also have to contribute to this, so there is clearly a new market need for collateral.

EMIR’s aim is to encourage market participants to use central counterparties (CCPs) for more trades. CCPs lower your collateral requirement significantly. Fixed income and repo traders have been doing this a lot in recent years.

Will CCPs be the counterweight to greater collateral demands in the market?

I think so. The question isn’t whether there will be enough collateral at all times for all market participants as the number of assets available to borrow is extremely vast. It’s almost impossible to predict if the evolution of CCPs on one side and higher collateral needs on the other will continue to balance out as there are further regulations to come and the full impact is always unpredictable.

Historically, the market has been able to adjust quickly to shortages, even if that means prices going up temporarily. There are also new lenders out there but again they come with a higher price.

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