Buy-side beware - the growing need for collateral
Despite considerable development of
collateral management applications, utilities and services – and the potential
benefits for asset managers from managing liquidity risk and meeting margin
call obligations – there has so far been limited appetite from the buy-side.
The lukewarm interest has been exacerbated
by the delay to EMIR’s requirements on OTC derivatives clearing and the
exchange of initial margin for bilateral OTC derivatives, as well as a lack of
clarity on the final regulations.
In the absence of a regulatory driver,
revenue considerations become critical. However, some products represent
functional overkill for asset managers, appearing sell-side focused.
There are also operational risk concerns
for those participating in agency securities lending programmes. This is
especially the case with third-party lending and exclusive deals on portfolios,
which all add complexity to the location of assets, including whether they can
be recalled on time for sell orders and assessing when assets are being used
for collateral purposes or in lending programmes.
Central clearing
Further muddying the water are CCPs’
activities, exploring the provision of cross-margining and tri-party
capabilities might further delay the choice between products. However, there
are some very clear benefits for a buy-side firm to develop a collateral
management capability in the short-term.
In the period leading up to the global
financial crisis, there was an abundance of cheap client clearing services.
Banks were almost exclusively the clearing members that provided these for
high-volume plain vanilla OTC derivatives such as interest rate swaps.
This continued in the post-crisis period as
regulation mandated the central clearing of OTC derivatives for most
counterparties, which led to increased demand. However, banks have been
burdened with being members of multiple CCPs to service their global buy-side
clients. This, combined with changes to capital requirements, suddenly made offering
client clearing services a less attractive revenue proposition, requiring
strict compliance and monitoring.
This has undoubtedly pushed up costs,
meaning buy-side clients transacting significant volumes across multiple CCPs
could certainly benefit from the ability to self-clear.
Minimising yield drag
Investment and wholesale banks have
traditionally been providers of liquidity to the buy-side. However, capital
adequacy requirements and balance sheet usage mean that collateralised
transactions versus cash have an adverse balance sheet impact, even with the highest
quality collateral. Where transactions are collateralised with non-sovereign assets
there is an impact on risk-weighted assets (RWAs) and capital adequacy ratios,
all of which is reflected in the rates they can provide.
There is value in seeking non-traditional
counterparties that don’t face the same constraints, such as other buy-side entities
including corporate treasury desks. In this context, tri-party looks very
attractive as it enables the collateral giver to commoditise pools of assets
and outsource the re-valuation, recalls and substitutions to the tri-party
agent. Services such as Euroclear’s RepoAccess take the headache out of
negotiating individual GMRAs with each counterparty. Other products are in
development so a different landscape is emerging.
Managing liquidity is a significant task
for portfolio managers and being prepared for investor redemptions, managing
portfolio restructuring, meeting margin call obligations, covering liquidity
shortfalls and investing excess liquidity has required investment in dedicated
teams and technology. Yet, with major currencies offering near zero or negative
interest rates, the disparity between the yield of a strategically-invested
portion of a fund and the portion that is invested in short-dated products is
considerable.
The impact of the poor return from the
liquid portion of a fund’s NAV on the overall return, the so-called yield drag,
could be partially mitigated by rebalancing the ratio of the strategically-invested
portion to the short-dated liquid portion.
The transformation of strategic investment
assets into high quality liquid assets (HQLA) would enable a similar liquidity
ratio but offer the ability to readily raise cash against the HQLA, or use
HQLAs to meet collateral obligations. The annual cost of collateral
transformation is a fraction of the yield improvement gained from reducing a
fund’s liquidity.
Collateral optimisation has traditionally
been a sell-side concern, as it is typically leveraged and focused on balance sheet
usage. The focus for the buy-side is different, with a decision process that
determines the deployment of expertise and resources for core activities while
outsourcing non-core activities. It is imperative that collateral management is
given attention so it can have an impact on the bottom line, rather than just ticking
a regulatory box.
Jonathan
Adams is a principal consultant and practice lead of Delta Capita
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