As we head towards 2020, many in the market continue to anticipate a rise in non-cash collateral use, particularly in the equities space. According to the 11th Securities Lending Market Report, published by the International Securities Lending Association (ISLA) in September 2019, non-cash collateral reached €1.5 trillion in 1H19, representing 67% of all lending business globally. While the vast majority of this can be attributed to European securities lending activity – the report found that more than 95% of all non-cash collateral was held within Europe’s triparty infrastructure – there is continuing momentum behind the push for equities as collateral in the US. Much discussed changes to the SEC customer protection rule 15c3-3 would allow US broker-dealers to pledge equities as collateral when borrowing equities, although this change has yet to come to pass.
“That revision would cause a significant increase in the amount of non-cash transactions and would allow firms to mobilise assets in more illiquid markets,” says Matt Wolfe, vice president of strategic planning and development at OCC. “If that were to happen, it is important that the services and technology available are able to handle the greater volume of non-cash collateral and changes that would occur to the equity collateral pool. That includes thinking carefully about the risk management of the loans that are being collateralised by equities and making sure that the proper surveillance and controls are placed around the account, for example, making sure that the collateral being provided is diverse and not highly correlated to the loaned securities.”
As the array of assets being posted as collateral evolves, it becomes increasingly important that firms posting collateral have an optimisation process and that collateral receivers have a strong collateral validation framework in place, notes Bimal Kadikar, chief executive officer at Transcend. “Firms posting collateral need to identify the optimal securities that maximise their own capital resources, considering all available asset types from across their enterprise, while eligibly meeting their client obligations. Firms receiving collateral need the ability to ensure that it complies with what they are expecting, especially as the collateral equation changes. A collateral validation framework can highlight if there is an anomaly or an exception to act upon,” he says.
Initial margin obligations prompt rethink
With four of the six phases of the uncleared margin rules (UMR) now implemented, the regulations are also beginning to reshape the type of collateral firms are looking to mobilise. One such example is money market funds, points out Ed Corral, global head of collateral strategy at J.P. Morgan. “Historically, money market funds have not typically been used from a triparty collateral management perspective. We are now seeing their potential among firms pledging margin to meet their segregated initial margin requirements. Interest in the ability to post money market funds is being driven by the buy-side community,” he explains.
There is of course no one-size-fits-all approach when it comes to the way in which firms are navigating the regulations. Some sell-side firms, many of which are now well-versed in UMR compliance after falling into scope of the initial roll-out phases, are starting to explore new opportunities around the type of collateral used for initial margin, points out John Straley, chief operating officer at DTCC Euroclear GlobalCollateral Ltd. “It was first thought that HQLAs (high quality liquid assets) such as treasuries and local European sovereign debt, were going to be the easiest assets to move between sellside firms and triparty managers,” says Straley. “What we have observed in the last few years, particularly as the initial margin waves came into effect, is a walking down from HQLA as firms consider whether they need to put HQLA into initial margin buckets.”
Meanwhile, in Asia, the uncleared margin rules are a contributory factor behind an uptick in local government bonds being posted as collateral. “Off the back of the regulatory changes, we’re seeing international institutions looking to finance more of the local government bonds - which they are receiving as initial margin from their non-cleared derivatives trades - with local brokers in markets around the region,” says Ed Bond, head of agency securities lending and collateral management, Asia Pacific at J.P. Morgan. “That’s a big shift and it means that our triparty platform must be able to support that demand. The main areas of focus are government bonds in Korea, Singapore, Hong Kong, Japan, and Australia. We have supported those markets for some time, but it’s only really now that we’re seeing demand pick up in Singapore, Hong Kong, and Korea.”
As balance sheets grow, firms are taking increasingly long positions in Asian markets, with a focus on Korean and Taiwanese equities expanding to encompass fixed income and greater exposure to markets such as the Philippines, Thailand, and Indonesia over the last 12-18 months, adds Bond.
It is worth noting that more than a third (37%) of government bonds held as collateral within triparty in the first six months of 2019 were Asian securities, according to ISLA’s latest Securities Lending Market Report.
When it comes to untapped potential in Asian markets, China should also not go unmentioned. In May 2018, MSCI commenced the partial inclusion of China A large-cap shares to the MSCI Emerging Markets at a weight of 5%. In February 2019, it went on to announce that the weight of China A large-cap shares in MSCI Indexes would be increased to 20% through a phased approach by November 2019. This follows initiatives to improve access to Chinese financial markets through the development of programmes such as Stock Connect. “There are still a lot of steps for the market to go through but the demand is there and the size of the financing requirements is increasing,” states Bond.
Using tech to take in the bigger picture
The move towards non-cash collateral and the broader range of asset classes is being leveraged by firms to more efficiently meet margin requirements, however, this can add another layer of collateral complexity, says Todd Crowther, head of innovation at Pirum Systems.
“There are a number of ways firms can better mobilise assets, whether that be turning to (triparty) agents to manage collateral on their behalf or utilising different market technologies which are enabling more streamlined instruction and delivery of collateral, such as the
This has given rise to the deployment of automation tools and online platforms that can adapt to firms’ changing collateral requirements and support efficiency, speed, and compliance in the face of the various headwinds reshaping the collateral landscape. Martin Seagroatt, marketing director for securities finance and collateral management at Broadridge, says: “Firms continue to invest in systems that can rapidly identify, allocate and mobilise idle collateral in an automated way.”
Such systems can also reduce the costs incurred by moving collateral, for example, on a cross-border, inter-company basis. J.P. Morgan’s Corral says: “If the collateral starts in entity A, say in Asia, and the firm wants to move it to entity B, in Europe for example, then they can make that move on our platform as a book transfer entry seamlessly and instantaneously without market cost. Our platform can also help dealers consolidate their activity in one place, providing a holistic and global view of their collateral obligations.”
A comprehensive outlook is becoming increasingly important to firms as they seek to take a more active role in collateral management. While collateral optimisation has traditionally been seen as selecting the most economically-efficient asset eligible for a particular trade, the influx of regulatory standards such as the Liquidity Coverage Ratio and the Net Stable Funding Ratio (NSFR) has had a growing impact on firms’ priorities when it comes to collateral selection.
“Over the last couple of years, dealers are realising that they are the ones who best know what is important to them on a day-to-day basis. While the responsibilities of triparty agents remain the same in terms of collateral eligibility, sufficiency, pricing, and haircuts, etc., there has been a trend towards self-directed allocations,” Corral explains. “Firms will have triparty balances with us or with other triparty providers, they will be doing bilateral trades, and/ or they will have collateral obligations on exchange at the different CCPs (central counterparties). From the triparty agent’s perspective, what the dealer is telling them to do may not always appear to be the most optimal course of action but the dealer is the only one who sees that entire picture and knows their entire collateral pool. Providing the right tools to dealers to support that flexibility is critical.”
This article features in the Collateral in 2020 Guide. Download the full guide here.