Increasing demand for collateral transformation trades could lift the securities lending and repo markets but potential hurdles could get in the way, according to a new report by consultant Finadium.

Some market participants believe there will be high demand for collateral upgrade trades when OTC derivatives are moved onto central counterparties (CCPs).

The report, Sizing up the collateral transformation trade, says that the evolution of such trades could determine the profitability, strength or even continued existence of some securities finance desks. Finadium adds that expected winners and losers are already emerging among asset holders, cash providers, securities lending agents, banks and repo desks.

The report says there could be a mismatch between lenders and borrowers in terms of the length of trades. Many lenders are comfortable with overnight trades where they can recall their securities at any time, while borrowers such as mutual funds that would want to swap low-quality collateral for high-quality assets to finance their derivative trades typically look for term trades.

“While six-month term loans or exclusives are an acceptable option for some lenders, terms can never be long enough for some borrowers. As one example, an insurance company with a 30-year interest rate swap and a shortage of acceptable collateral for CCPs will never be able to borrow enough government bonds for the entire 30 year period. This creates an outstanding maturity mismatch problem for both derivatives investors and regulators.”

Finadium says that securities lending agents are approaching their larger clients to gauge their interest in auctioning off fixed income portfolios, which is presumably for collateral transformation trades. The consultant suggests that some lenders are accepting these deals without having full knowledge of the terms:

“We see that lenders are not often aware of all of the terms of the deal, at times accepting it knowing only that the transaction is for non-cash collateral and that indemnification against counterparty borrower default remains in force. Although agent lender reporting of non-cash collateral holdings can be erratic, the guaranteed revenues of an auction or exclusive seem to be enough to convince some lenders to move forward.”

Finadium stresses the importance of having transparency in the marketplace, which comes at a time when the Financial Stability Board (FSB) is consulting on new rules for the shadow banking system. The FSB’s proposals include the introduction of trade repositories in the securities lending and repo markets in order to increase transparency.

“Collateral transformation can obscure systemic risk unless the trail of paper moving around is transparent and regulators understand and can process the data.”

The report also considers whether there will be a shortage of high-quality collateral – which would determine the amount of new business for securities finance desks.

Finadium says that while there is no “absolute” collateral shortage, the decrease in rehypothecation of collateral could exacerbate the shortfall. The report points out that CCPs do not rehypothecate collateral while there is growing popularity in having segregated collateral with tri-party custodians.

“By reducing collateral in circulation, shortages are indirectly created,” says Finadium.