Spring 2014

COLLATERAL: Season of changes

TreeAs collateral management becomes a bigger issue for asset managers, Nicholas Pratt examines the efforts to make collateral more mobile. Collateral management has undoubtedly become a much bigger concern for asset managers in Asia than it used to be. The Lehman Brothers default in September 2008 was a watershed moment for investors and capital market participants, sparking a sudden realisation that collateralisation makes for much more robust credit risk management. It also led to the wave of regulations that require greater use of collateral – from the European Market Infrastructure Regulation and Dodd Frank to Basel III, which imposes a heavier capital charge on assets that are collateralised. And then there is central clearing for over-the-counter (OTC) derivatives. Interest in collateral is growing because of fears that the introduction of central clearing will spark a global shortage of the high-quality collateral needed to meet new margin requirements for trading OTC derivatives. This fear has spread to Asia, where the use of collateral has traditionally been cash-based. “Economics tells us that we should be moving towards bigger pools for collateral purposes, but whereas this is much more easily achieved in the West, where there are bigger asset pools, it will be interesting to see how this is actually achieved in the Asian markets,” says Ian Stephenson, global head of fund services at HSBC. This development has been keenly pursued by the prominent providers of tri-party collateral management services looking to build a global pool of assets eligible for collateral purposes by any client anywhere in the world. The international central securities depositaries (ICSDs) Euroclear and Clearstream are both developing collateral management services in Asia, working with a number of regional CSDs, central counterparty (CCP) clearing houses and exchanges in order to improve the mobility of high-quality collateral across borders within Asia Pacific. For example, Clearstream has partnered with the Australian Stock Exchange and, more recently, the Singapore Exchange to provide a collateral management service for the assets held by the exchanges’ securities depositories. Meanwhile, Euroclear has been developing its Collateral Highway service, designed to create a global pool of assets that can be used for collateral by clients and has partnered with the Hong Kong Monetary Authority alongside others. Central to both of the ICSDs’ services is the mobility of collateral, a particularly important issue within the Asia Pacific markets where cross-border activity has often been held back by a lack of interoperability between regions. “Your chosen collateral management solution needs to be able to mobilise collateral to wherever it is needed in an automated and real-time manner,” says Carlo Minieri, Euroclear’s director of fund solutions in Asia. “I think this is the real issue that collateral management providers are trying to overcome.” The infrastructure put in place has yet to enjoy the same level of success as the equivalent structures in Europe and the US, but Minieri is confident that it will evolve in time, especially if cross-border initiatives like the mutual fund recognition scheme between China and Hong Kong as well as some of the Asian funds passport projects prove successful. The question, though, is how long will this evolution take? DOMESTIC COLLATERAL
BNY Mellon, like many custodians, has a variety of collateral management services in the Asia Pacific market and operates as an initial margin segregation agent and a tri-partite collateral management agent. The majority of collateral on its book in the Asia Pacific market is used for domestic not cross-border purposes. “The domestic collateral management market is more resilient than the cross-border market once it is established, whereas the cross-border market is much more fluid,” says Dominick Falco, Asia Pacific head of global collateral services. “It can be hard to access different markets and harder to track the movement of collateral across borders.” Despite the predominance of in-market collateral management, Falco says he does expect cross-border collateral management services to grow. For example, there are an increasing number of collateral upgrade trades where clients are borrowing Japanese government bonds (JGBs) and other high-quality fixed income assets and then offering equities from outside of the Japanese market as collateral, says Falco. “Regulation is also starting to play in our favour. There are more transactions that now require collateral than was previously the case. More OTC derivatives need initial margin and two- way margining will be required in future. Regulation reflects that collateral is a much more important part of firms’ risk management framework and that is the biggest opportunity for us.” For example, the fears of a global shortage of high-quality collateral has helped bring Asia into a global collateral management context. “Clients that are holders of JGBs are looking to increase their ability to generate returns on those assets and those pools of assets are being made available to brokers. And in an international context, Asian high-quality fixed-income, such as JGBs, is in high demand.  So it is a demand-driven market in many ways.” Japan accounts for the largest proportion of collateral on BNY Mellon’s book and much of it is also more portable than in other Asian markets, says Falco. “Japan is one of the best markets in terms of high-quality assets that are affordable and easily tapped into and this is because of the cross-border activity where international players are using non-Japanese assets as collateral.” GAME-CHANGER
The use of funds as collateral is still not as big a development in Asia, certainly not to the same extent as in Europe, says Falco. This is also reflective of the fact that asset managers have not shown the same level of interest in collateral management as the global broker dealers, he says. “We have some synthetic ETFs that required collateral but there has not been as much use of collateral management services from asset managers as there has been from broker dealers. But I expect this interest to increase.” It will not be one game-changing event that sparks a sudden wave of interest, he says: “It really depends how individual regulations will impact clients.” This covers only the US and EU-based rules like Dodd Frank and the European Markets and Infrastructure Regulation, but another layer of domestic regulations in each Asian country and how all these come together. For example, Falco says, if there is a new rule that affects fund managers in one Asian country that could well bring a sea-change in the use of collateral management. Citi is another custodian offering a range of collateral management services in Asia including margin calculation and posting, OTC valuation of assets and clearing, as well as collateral transformation. Pierre Mengal, Citi’s regional head of investment and financing solutions for Asia Pacific, says asset managers’ original interest in collateral management services was based on their need to address their internal management processes. Many asset managers and other buy-side firms have been relying on spreadsheets and are looking to have a more sophisticated process by outsourcing to a custodian that will act as their collateral agent.    However, following the wave of regulations and the imminent introduction of central clearing for OTC instruments, attention has switched to the much-publicised fear of a global collateral shortage and the liquidity management implications. “This has led to more focus on inventory management,” says Mengal, who identifies four steps in the process.
The first is knowing where collateral sits. It also needs to be mobilised so it can be used to meet the deadlines from collateral arrangements or clearing agreements, and optimised so that firms know which collateral is most suitable for separate counterparties, especially for those that were previously using cash for collateral and not assets. ELIGIBLE ASSETS
The final stage is transformation, something that could prove popular given the limited range of asset classes demanded by CCPs – domestic bonds, US treasuries, selected EU government bonds and JGBs, which remains the Asian asset class most in demand. A number of government bonds, such as those in Singapore, are highly rated but have limited liquidity due to the lack of a secondary market which reduces their attraction as collateral. “There is not a huge range of eligible assets at this stage and I am not sure this will change much in the short-term,” says Mengal. “Each Asian market has developed their own national CCPs and they all prioritise domestic bonds and the traditional high grade government bonds usually accepted. I don’t expect their eligibility criteria to broaden or for them to start competing with each other on that basis as this would create a new systemic risk.”   The trend for greater cross-border use of collateral is growing, especially in the more mature Asian markets such as Singapore, Hong Kong, Australia and Japan. However, he says while there are certain markets, like Korea, where collateral is managed through a national CSD, the mobility of collateral across borders is not the main issue. The challenge for buy-side clients and even for brokers is on managing the assets they hold internally and how it can be used as collateral, he says. “Many of them do not know what they are sitting on. Enterprise-wide collateral management is the first step, especially for those buy-side firms that are using non-cash collateral for the first time.” ©2014 funds global asia

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