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).

Some institutions will prefer a client clearing relationship to direct membership, because the volumes traded in clearable instruments may not be large enough to justify the costs and responsibilities of directly joining a CCP. Client clearing provides an exemption from responsibilities of the clearing houses’ default management processes and enables them to avoid pledging money to the default fund.

WHY IS TRANSFORMATION NEEDED?

Collateral transformation is a service offering—created by the indirect clearing relationship—in which FCMs can finance the margin calls for variation and initial margin received from CCPs. It is the process of upgrading collateral, most commonly achieved through the following process:

1) the client pledges corporate bonds to a FCM

2) the FCM then performs a repo transaction to switch the bonds for cash

3) the FCM then pledges the cash to the CCP to cover margin

The client pays a fee to the member for providing this service, but collateral transformation increases a number of risks elsewhere and raises a number of questions, including:

• Will there be unintended consequences for putting the repo market between the buy side and CCPs?

• How will collateral transformation react in a stressed market?

• What is the potential for liquidity risk and rehypothecation?

• What are the dangers in the new OTC landscape?

INCREASED LIQUIDITY RISK VIA THE REPO MARKET

Many buy-side firms have raised concerns about their ability to pledge eligible collateral for CCP initial margin calls, delivered in bonds. For example, pension funds invest in securities with long-dated maturities; to match the liabilities of the pensions they pay out. Withholding a portion of the assets of the fund to buy eligible collateral for a clearinghouse will detract from the performance of the fund. If the fund does not possess eligible securities, it will have to buy or borrow assets—requiring expertise outside of the investment fund’s mandate or even requiring it to trade in a market to which the fund does not have access. These are all reasons why funds may choose to use a collateral transformation service rather than transform the assets themselves.

The collateral transformation service would appear appropriate under normal market conditions, but as markets become stressed, the FCM has the right to refuse to fund the margin call completely or to use a number of techniques to reduce their risk. These can include:

· Increasing haircuts on bond pledges

· Reducing bond eligibility

· Refusing to accept new business

This can cause a significant spike in the funding requirements of a transformation service user to fund its positions, causing such significant ramifications as:

· The demand for high-quality collateral can drive up the price of eligible assets and squeeze the market.

· The refusal by the FCM to accept lower-quality collateral for the repos would force a sale of ineligible assets to raise cash, further driving down the price of the assets.

· There will be a break-even point for each trade, where the financing cost forces the termination of all cleared positions to prevent the client from receiving a margin call that cannot be met.

If the increase in securities to cover a margin requirement is replicated across all trades on the swap portfolio, the amount of securities required to fund margin increases significantly. In this case, a choice must be made:

· Borrow cash and pledge unsecured (which is expensive and has a large opportunity cost)

· Borrow cash and perform a reverse repo to bring in more bonds that can be repo’d out to lower the funding cost of the cash

Either option requires the firm to increase its leverage and stretch its balance sheet with the hope that the market stabilizes before credit lines are cut off.

REHYPOTHECATION

The flow of assets in collateral transformation—and, ultimately, the margin pledge—can be complicated. It is also important to know which leg(s) of the transaction comes under which legal framework. This distinction is important and critical to understanding the rights the client has to the original asset, in the event of an FCM default. The collateral transformation may be performed under a Global Master Repurchase Agreement (GMRA), meaning the bond sold in return for cash would not be required to be segregated from the FCM’s assets. The FCM could then rehypothecate the bond by performing a reverse repo to sell the bond to the market.

The cash raised from the collateral pledge would be covered under the FCMs clearing agreement, ensuring it was segregated from house assets. US legislation (SEC Rule 15c3-3) limits the amount of rehypothecation that the FCM can perform, ensuring that the FCM does not stretch its balance sheet beyond capacity. The UK has no statutory limits for rehypothecation of collateral. The merry-go-round of rehypothecation (and understanding exactly where assets lie in the event of a default) is a headache still being experienced by MF Global’s clients. Even if assets are pledged to a US entity, it is not yet forbidden to transfer them to a UK subsidiary to take advantage of the more generous rehypothecation rights, as shown in the diagram below. In the defaults of both Lehman and MF Global, this is a distinction many clients have fallen victim to.

CONCLUSION

FCM clients require access to CCP-eligible collateral. Collateral transformation helps address this requirement but also creates a dependency on the short-term repo market. As Lehman Brothers discovered, when the repo market seizes up, haircuts are increased and bond eligibility (as determined by repo counterparties) can change significantly and quickly. Counterparties will only accept the most creditworthy collateral for the repo trade, limiting access to the funds required for the CCP margin. The sharp increase in funding requirements to meet margin demands can result in the default of a firm if the assets are not readily available.

FCM clients must be cautious and take steps to ensure collateral transformation will be provided in a stressed market. If the FCM reduces bond eligibility, it will transform only the most credit-worthy bonds and the client may find itself without access to eligible collateral and unable to meet margin calls from the FCM.

The government bailouts in 2008-2009 demonstrated what happens when insufficient capital levels are maintained with only a small percentage of the OTC market being centrally cleared. Increasing the volume of cleared trades will significantly raise the level of capital required to cover resulting liabilities. And, as clearing grows, regulators must view access to liquid collateral as a key component in managing systemic risk in the market.

After all, is the new swaps environment any more stable than the one we have now?


Richard Ellis is a manager for Sapient Global Markets