Richard Ellis of Sapient Global Markets looks at the liquidity and market risk issues around collateral transformation.
In derivatives trading, collateral is posted against trades
to act as insurance and protect against a default. This
collateral is almost always in the form of cash or highly
liquid securities. Presently, regulators are requiring the
majority of over the-counter derivatives contracts to move to a
central clearing model. As a result, the clearing system will
require several trillion dollars in additional collateral.
The process of collateral transformation is simple:
custodians with high credit ratings and large balance sheets
provide their clients access to high-quality collateral in
exchange for lower-grade corporate debt (or other securities)
and associated fees. Given the revenue potential of
transformation services, many custodian banks have already
begun investing in this offering.
Sapient estimates that 90% of sell-side firms intend to
offer collateral transformation services.
A NEW CLEARING STRUCTURE EMERGES
Both the Dodd Frank Act and the European Market
Infrastructure Regulation (EMIR) mandate that all eligible
swaps traded by Swap Dealers (SDs) and Major Swap Participants
(MSPs) be cleared. Proposed Dodd-Frank regulations would impact
all 822 ISDA swap dealing institutions, but—as an
indication of how much migration is yet to occur—there
were only 48 members of LCH.Clearnet (the world’s
biggest OTC interest rate swaps clearing house) as of January
2012. Over recent months, clearinghouses have adjusted their
membership requirements to facilitate wider access to clearing
for market participants. There will, however, still be a large
portion of the swaps market that will choose to enter into
third-party client clearing relationships. In a client clearing
relationship, a Fund executes a trade with a Bank and the Fund
uses a Futures Commission merchant (FCM) as an intermediary to
route its trade to the CCP. For the life of the trade (in the
US model), the Fund faces the FCM under a client clearing
agreement. Under the European clearing model, the intermediary
is a Derivatives Clearing Member (DCM).
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