Winter 2013

COLLATERAL: Collateral workout

RunnerAsset managers in the Asia Pacific region are flocking to third-party collateral management services as the approach to collateral in the region matures. Judith Evans reports.

Asia has lagged the US and Europe in taking an active approach to collateral, with many managers still using manual processes involving spreadsheets and emails.

But they are now joining sell-side institutions in seeing a need for more efficient, joined-up systems in what once was a minor back-office function.

Successive waves of regulation affecting the global collateral pool are acting as a catalyst, custodians and investment banks say. “In Asia as yet, there is no mandatory clearing for buy-side clients, but everyone knows it’s coming,” says Swen Werner, head of collateral management product for Asia Pacific at JP Morgan. “Clients see an impact on the costs of trading if they don’t collateralise, and they can see it helps to have a more robust, more controlled collateral programme.”

There is “a bit more hand-holding” with some clients in the region than elsewhere, Werner adds, as clients may be starting “from day one with a third-party provider”.

One key element of collateral management, providers agree, can be overseeing collateral held within an organisation that may have previously been divided between different internal silos rather than viewed as a whole.

NEVER DONE BEFORE
Dominick Falco, Asia Pacific head of global collateral services at BNY Mellon, agrees. “Asset managers recognise that they need to do something around collateral management that they’ve never done before.”

The fiscal prudence of most Asia Pacific governments means it is not a collateral-rich region; it is also fragmented, with international clearing houses seeking yen- or Australian dollar-denominated assets while their local counterparts tend to prefer those in the domestic currency.

Post-financial crisis regulation, including the Basel III banking standards, the Dodd-Frank Act of the US and the European Market Infrastructure Regulation are set to require central clearing of over-the-counter (OTC) derivatives transactions, resulting in demand for more and higher-quality collateral.

BNY Mellon has been working to funnel Japanese government bonds (JGBs) from regional financial institutions into the global network of broker-dealers, says Falco.

Chee Kiang Ng, director at Euroclear, also cites JGBs as an example of how bonds can be used as collateral in a variety of cross-border transactions. “Picture this: a piece of JGB can be used by a Japanese bank to satisfy liquidity requirements with the Bank of Japan during the Asian business day, and that same asset can then be re-used with a European counterparty later in the afternoon. By close of the Japanese business day, the same security is then realigned and available to be pledged to the Fed [Federal Reserve] to draw on USD liquidity to support that firm’s US activities.”

In Hong Kong, BNY Mellon has been working with clients seeking to collateralise over-the-counter derivatives transactions for Hong Kong exchange-traded funds (ETFs).

And in Singapore, Clearstream announced in September it had signed a deal with the Singapore Exchange (SGX) to explore the launch of a collateral management service for assets held at SGX’s securities depositary. Clearstream is focusing on managing collateral across time zones without transferring assets out of the domestic environment, using the liquidity hub global outsourcing system first developed in Brazil.

It aims to work with local partners in Asia to ensure “you don’t touch on the existing infrastructure provider’s setup, and you don’t suck out domestic collateral into an account structure where an infrastructure provider can no longer act in case of a crisis”, says Stefan Lepp, executive board member.

JP Morgan launched its global Collateral Central service in June, allowing clients to track and optimise assets, including those held with other custodians. That followed Euroclear’s launch a year earlier of its collateral highway, which now has the Hong Kong Monetary Authority, among others, on board.

CRIPPLING SQUEEZE
For providers, collateral management is increasingly big business.

Most custodians play down talk of a crippling squeeze on collateral in the coming years, but at the same time admit that warnings of such a crisis have focused minds on maximising collateral.

“The discussion was healthy, in terms of alerting people,” says Werner. “A lot of research these days suggests that people are responding by making collateral strategic to their way of doing business.”

A study by Six Securities Services published in September, which surveyed senior figures responsible for collateral management at 60 leading financial institutions in the UK, France and Germany, found that more than half believed there would be a world collateral shortfall by 2015. But estimates of its size range from $10 billion to several trillions of dollars – reflecting ongoing uncertainty.

“While the global collateral pool exists for no squeeze to exist … that does not mean that acquiring the right collateral will be cost-efficient for each market participant,” says Josh Galper, managing partner at the consultancy Finadium.

He notes the International Monetary Fund calculated that investors around the world held $41.3 trillion in government securities at the end of 2011. “But the cost of holding appropriate collateral for posting may be unattractive.” Without collateral management “this will result in investors making difficult choices to either change investment strategies, reduce returns, hold unattractive or inappropriate long holdings for the purpose of posting collateral, or other disadvantages”.

Falco says a “mosaic” of regulations is on its way, noting that it is unclear exactly how standards such as Basel III, in conjunction with local regulations, will play out across the region. Basel III has a phased implementation from 2013 to 2019. “Local regulators will want to be somewhat in compliance with what global regulations are doing. At the same time, for a lot of exchanges that are for-profit entities, they will want to position themselves against the competition.

“There’s a conflict between how the international regulation plays out and how fast you can introduce new regulation to draw additional business into the country.”

Chee Kiang Ng highlights that asset managers will for the first time be required to post initial margin as part of the drive towards central clearing of derivatives. This is helping to send them towards third-party providers as “the administrative burdens associated with posting margin are complex and cumbersome and they are not part of the core competence of the asset managers”.

Six Securities Services found that central counterparty acceptance was the most important factor for the asset managers it surveyed in choosing a collateral management system – some 38% said this was top of their list.

The ability to request segregation of margins, real-time settlement and real-time reporting were also important priorities, with cost the main factor for only 2% of respondents.

Galper highlighted that third-party collateral management services could not be used as a substitute for comprehension of the procedures involved. “Outsourcing relieves a daily operational burden but not the requirement for understanding the process.”

TRANSFORMATION
There is also a buzz around the concept of collateral transformation, in which lower-grade collateral is switched for cash or government bonds via the repo market.

“A loan of US treasuries may yield 6 bps for cash collateral but 45 bps for non-cash collateral such as corporate bonds,” says Galper. “So long as the agent lender indemnification is in place, lenders can earn the increased revenues ... with the knowledge that their securities will be returned in the event of a counterparty default.”

But he says transformations “do introduce a new degree of interconnected risk in the markets”. For example, if a borrower posted corporate bonds and received government bonds in return, then posted those government bonds at a central counterparty for an OTC derivatives trade, Galper says then any participant failure at the central counterparty could potentially negatively impact the securities lender of the original government bond.

There are concerns that greater collateralisation, aimed at reducing risk, may in some cases increase it – but market players say this depends on the integrity of the systems used.

“You should start to look at optimisation before you consider transformation,” says Werner. But he adds that aspects of what is now called transformation include “some very old, traditional stuff, such as securities financing which is very important for us as an organisation and our clients”.

Lepp says: “We do support reuse functionalities, but only in an environment where any reuse activities are executed within a closed system to ensure transparent and reliable tracking of each transaction.”

He says this is to avoid new systemic risks. “In case of a default or disruption you are able to backtrack all activities, but also backtrack all collateral to its origin.”

©2013 funds global asia

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