Estimates on the amount of additional collateral required under the G20 mandate to clear standardised OTC derivatives vary from the hundreds of billions to the trillions. Coming as regulation and financial prudence is already pushing up capital ratios, this collateral squeeze represents one of the largest challenges to the implementation of the OTC clearing mandate.
The additional collateral requirements of OTC clearing are inescapable. Indeed, one of the key motivations for the move to OTC clearing is to increase the level of margin posted against OTC derivatives contracts. However, there are a number of initiatives that can ease the collateral squeeze from banks and technology providers offering collateral optimisation and transformation services to CCPs accepting a wider range of instruments as collateral or offering cross-margining across instruments.
Under the bilateral OTC framework, few buy-side firms were required to post substantial initial margin and often no variation margin. In a 2010 report, Tabb Group said that moving the plain vanilla IRS customer-to-dealer business to central clearing would require an additional $240bn in collateral. Moving all OTC derivatives would need over $2.2tr, the research said.
The call for additional margin comes as balance sheets are squeezed elsewhere. In Europe, Basel’s capital requirements set out in Solvency II and CRD IV also place significant pressures on the balance sheets of banks and other institutions at the same time that the OTC clearing mandate is due to come into force.
Meanwhile there has been a significant decline in the overall availability of collateral with a study by Manmohan Singh of the IMF estimating a decline of roughly $4-5tr since the collapse of Lehman Brothers.
Optimising the squeeze
All this creates a significant collateral squeeze. Ted Leveroni, executive director of strategy at Omgeo, compares the issues facing the industry in terms of collateral requirements to the need to end dependency on oil: there are several options that will each alleviate small parts of the overall liquidity challenge, which in aggregate will make a real difference and ease the collateral liquidity strains.
“Nobody really knows how much additional collateral will be needed, but it will be a lot. There are a number of ideas around how to handle the shortfall and some are absolutely necessary,” he says.
One such method is collateral optimisation, the process in which firms can quickly ascertain which assets in their portfolio are cheapest to deliver to satisfy margin calls, increasing the efficiency of assets. Leveroni said that this process, which was once done manually, is now being automated.
Calypso has launched a number of products to meet the demand for collateral optimisation. Sanela Hodzic, managing director of strategy and business development at Calypso, says that the move to clear OTC derivatives is changing the optimisation process.
“There are a number of key changes from the fact that bilateral markets do not post initial margin down to the fact that CCPs only accept certain types of collateral. This propagates all the way from the CCP to the clearing member to the ultimate client. That whole collateral flow requires new technology and a different workflow that you have to adjust your existing infrastructure to support.”
Transformers: collateral in disguise
Collateral transformation is also an option for firms. A firm may have an asset that cannot be used to post as margin, but they could swap or repo that asset for eligible collateral. When the OTC clearing mandate was announced in 2009, a lot of banks got excited about the prospects for collateral transformation as a business line. However, for many, the enthusiasm for such services has since waned.
Minling Chen of financial service consultancy Baringa Partners says: “What we are hearing from our clients is that as they start to work out the capital implications and the impact on their balance sheet of offering [collateral transformation] to their clients, the benefits of doing so might not add up.
“A lot of banks are now considering offering the service only for their top clients; they are viewing it as a value added service to retain key clients rather than a revenue generator offered to all.”
Leveroni also recongises that trend: “Six months ago, every brokerage or bank worked on the assumption that collateral transformation was something they could provide, but as they started to look at this in more detail, they realised that it was not a simple issue.
“Firms may not have access to the cash or sovereign debt they need and so they would have to borrow those assets. The largest holders of sovereign debt, however, might not want to engage in a transaction whereby they are opening themselves up to that level of credit risk with a single fund.
“Counterparties would therefore require the bank or brokerage to stand in between the trade and guarantee the fund, which would have significant implications for the balance sheet. As such banks may decide only to offer collateral transformation services to their largest clients.”
Onus on the CCPs
Technology and collateral transformation will go some way to alleviating the problem as processes to ascertain the cheapest to deliver collateral increase the efficiency of assets, however, CCPs will also have to increase their offerings to ease the collateral squeeze.
There are two core ways in which CCPs can lower the required amount of collateral: lower margin requirements and accepting lower quality assets as collateral; and cross margining, netting exposures across instruments or asset classes.
Last year LCH.Clearnet joined the CME and ICE Clear Europe in accepting gold as collateral from some clients to margin against certain instruments. Last week, ICE Clear Europe announced that it would begin accepting pledges of security interest of collateral, a process through which the buyside still owns and operates the assets but the CCP holds a legal claim on those assets. LCH already offers such a service.
However, CCPs are unwilling to go much further down this path, for obvious reasons. At the ISDA conference this month, ISDA chairman Stephen O’Connor warned CCPs not to compete on collateral requirements in “a race to the bottom”. Nor will right-minded regulators allow it. Some efficiencies can certainly be found but margining different asset classes against each other on the basis of historical models of their correlations should set alarm bells ringing.
Another strategy employed by CCPs to mitigate the collateral squeeze is cross-margining. This has taken centre stage in recent months with a raft of agreements between exchanges and CCPs and announcements from CCPs about new initiatives to cross margin instruments. At the FIA conference in Boca in March, both LCH and CME announced portfolio margining initiatives and this will be a key battleground for CCPs.
Others are proposing more innovative solutions. The recently approved European Markets Infrastructure Regulation sets out an exemption for pension funds from central clearing until products are developed that would reduce the need to sell assets to post collateral.
Matthias Graulich, executive director at Eurex Clearing, says that one such product could be a non-cash variation margin swap instrument.
He says: “This would function in a way that a pension fund would provide securities to fund its variation margin requirements. If the fund holds a gain, it would get a credit offsetting its initial margin requirement. This solution will only be possible if it is an industry agreed initiative.
“The alternative way is for a CCP to support and facilitate the way that the market operates today. Under this model, the CCP would offer cleared solutions, converting securities into cash through securities lending or repo products. However, such solutions are fragile if liquidity dries up in these products in a crisis situation.”
There is some evidence that the total required collateral will fall naturally. In other areas of the market, where OTC clearing has been introduced, this is exactly what happened. Richard Baker, chief executive of the Cleartrade Exchange, points to the freight derivatives market as an example of this trend.
“When the transition to OTC clearing began, we saw rates of $15-20 as initial margin being demanded by the clearing house. If you compare that to today, where initial margins are around $7-12, the initial margin costs have come down by 50% in three to four years.
“The reasons for this vary between asset classes. In some we have seen more entries into the market and as a consequence volumes have gone up and the cost of clearing has come down. We saw an increase as well over the past four years of new clearinghouses competing for business."
Mitigating the collateral squeeze matters. If margin demands on users of derivatives are too high, some institutions will simply not trade, impacting liquidity and exposing them to market volatility. There is no silver bullet, but collateral optimisation and transformation as well as cross-margining will go a long way to easing the collateral squeeze. As will exemptions for certain market players, to which we turn in the next instalment of this series.
Read more in this series:
OTC clearing: Does the market need a mandate at all?
OTC clearing II: Who should decide what has to be be cleared?
OTC clearing III: How many CCPs will there be and how should they compete?