A decade has passed since the opening act of the financial crisis. It was in June 2007 that the first unsettling harbinger of the storm to come manifested itself in the bailout of two subprime mortgage-laden hedge funds by their sponsor, the now long-defunct Bear Stearns.
Perhaps surprisingly, 10 years later some core elements of the regulatory reforms enacted in the wake of the crisis are still in the process of being implemented. For the securities financing community, the most pertinent of these reforms is the ongoing introduction of margin requirements on non-cleared over-the-counter (OTC) derivatives trades across the G20 economies.
These requirements oblige counterparties to bilateral derivatives trades to post collateral against swaps, forwards and other OTC contracts limiting the risk exposure of both parties by pledging initial margin (IM) at trade inception and daily variation margin (VM) in response to mark-to-market moves in the value of the underlying reference entity.
The rules are being introduced sequentially, with the largest international derivatives dealer banks becoming the first group subject to the requirements for posting IM in
March 2017 saw VM posting requirements introduced for all market participants while September 2017 saw the IM rules expanded to capture approximately six additional banks with notional derivatives balances of over $2.25 trillion.
September 2018, 2019 and 2020 will see the thresholds for mandatory compliance with the non-cleared margin rules progressively drop until notional OTC exposures of just $8 billion will be sufficient to capture counterparties under the requirements.
A multi-trillion dollar commitment
As larger and larger swathes of the global buy-side community are captured by the requirements, the international demand for cash and eligible securities to post as margin is almost certain to skyrocket.
Quantifying the extent of this global demand is not easy. In 2012, the International Swaps and Derivatives Association estimated the number could be as high as $10.2 trillion.
In a 2011 piece of research, the US Office of the Comptroller of the Currency estimated that the IM bill alone for a single year could be as much as $2.5 trillion.
Whatever the true aggregate number is, the sheer volume of cash and securities, highly-rated government securities, in particular, that will be needed to meet these mandates in the coming years represents an unpreceded challenge for global funding markets.
It’s a challenge that is only being compounded by the heightened capital and liquidity standards banks are being required to meet under the Basel III framework.
The interaction of Basel standards with the expansion of the non-cleared margin rules means that the international buy-side will find itself asking banks for trillions of dollars in supplemental funding at the very same time that dealers are stockpiling cash and securities in order to meet their own capital and liquidity commitments.
New research study
In order to ascertain the extent of the margin challenges facing the global buy-side community, BNY Mellon partnered with PwC in the first quarter of 2017 to conduct in-depth research into the situation on the ground for financial end users.
The resulting study, Collateral: The New Performance Driver, draws upon more than 140 interviews with senior executives from 121 buy-side entities located in North America, Europe and Asia Pacific. We discovered that although the non-cleared margin obligations are yet to affect buy-side firms, the liquidity and funding situation globally is already becoming tenuous. An overwhelming 93 percent of study respondents reported that they are already experiencing an increase in margin calls and demand for high-quality liquid assets (HQLA) as a result of the uncleared margin regulations.
The research also revealed that assets under management will likely be a key differentiator in determining which entities are able to readily access liquidity and which are not. Of medium and small asset managers, 29 percent expect to face challenges around short-term liquidity but that number virtually halves to just 15 percent for the largest tier-one fund managers.
Perhaps the most eye-opening concern—expressed by fund managers of all sizes and all types—was that the next market stress event will occur not because of a lack of collateral in the financial system, but rather due to the inaccessibility of this collateral.
Solving the liquidity conundrum
Given these mounting concerns, participants in our research study identified six distinct tools and services that they intend to utilise in the coming months and years to ameliorate these collateral pressures. These services run the gamut from the very simplistic, to the highly sophisticated.
- Deepening and expanding relationships with dealers: Unsurprisingly, by far the most popular solution favoured by the global buy side to meet their future collateral and funding needs is to simply consolidate existing bank relationships. Some 71 percent of respondents plan to increase the volume of business transacted with a handful of bank counterparties in the hopes of receiving preferential access and pricing as a highly-valued client. Also, 48 percent intend to expand their number of dealer relationships.
- Make increasing use of securities financing: The economics of borrowing assets to meet margin requirements have become increasingly attractive in 2017 as low yields and strong investor demand for HQLA has driven up the cost of highly-rated government securities. In the face of high prices to own sovereign debt outright, the securities lending and repo markets offer the buy-side a cost-effective way to post HQLA as margin without the painful price tag.
- Centrally clear securities financing trades: Clearing repo and securities lending trades at central counterparties (CCPs) such as the Fixed Income Clearing Corporation can deliver further cost efficiencies. Dealer positions facing a CCP attract a lower counterparty risk capital charge than bilateral exposures, and offsetting positions can be netted out against one another. Both of these efficiencies can be passed through to clients in the form of cheaper funding.
- Utilise collateral transformation and upgrade services: Insurance companies and pension funds generally maintain very small cash balances—as little as 1 percent of assets in the case of some pension companies. Both types of entity typically hold very large portfolios of investment-grade corporate bonds, but these securities are generally ineligible to be posted as margin. Collateral upgrade and transformation services offered by banks let buy-side firms exchange ineligible corporate paper or cash equities for government securities or cash that can be pledged as margin, allowing them to meet collateral requirements without having to hold non-yielding cash reserves that represent a drag on investment performance.
- Engaging non-dealer counterparties: With traditional market making dealers facing liquidity constraints arising from Basel III and other post-financial crisis reform initiatives, buy-side firms are exploring the feasibility of sourcing and exchanging funding and collateral directly with fellow non-dealers. This cohort of potential counterparties includes corporates, sovereign wealth funds, cash-rich market utilities as well as fellow buy-side entities such as hedge funds and asset managers. The major obstacle holding these relationships back are the operational, connectivity and credit assessment hurdles that need to be overcome.
- Participate in peer-to-peer networks: Perhaps the most promising of all the solutions being considered are electronic networks that allow peers to trade with each other. The basic concept is to enable dealers and non-dealer counterparties to transact with each other on a single platform. Such a solution would overcome the impediments to non-dealer trading by having a single onboarding process for each participant on the platform that allows them to face every other counterparty in the network. All of the necessary connectivity and documentation to permit a private equity fund to trade with a corporate is provided by the platform, opening up the entire universe of non-dealer liquidity through a single portal.
A prominent example of such a peer-to-peer platform is BNY Mellon’s electronic cash and collateral marketplace DBVX. Utilising a single interface, DBVX users enjoy all the usual benefits of electronic trading—such as real-time live prices, a variety of execution methods and pre-trade anonymity—with the ease of a single legal construct that opens the door to a global network of liquidity.
DBVX users can also define their own trading parameters, determining which counterparties they want to trade with and which counterparties are able to see and bid on the liquidity that users themselves are extending. For large buy-side institutions with numerous affiliates, the platform can be configured so that liquidity offered by subsidiaries within that firm’s own corporate group is given seniority in matching, promoting internalisation of trade flows.
Tools like DBVX reflect the dynamism the financial services industry is demonstrating in developing imaginative and innovative solutions to overcome the collateral and liquidity challenges that lie ahead. Although the scale and extent of that challenge remains unclear, it seems certain that securities financing will be at the heart of many of the service offerings that the market develops in response.