Banks’ low-quality collateral push sparks concern

By:
Heather McKenzie
Published on:

Banks claim new regulatory and market practices mean collateral should be of high-quality, but in practice they are willing to accept low-quality securities as long as it’s cheap. At the same time, financial institutions, exchanges and financial intermediaries are busy touting their lucrative collateral-transformation and sourcing services.

The seeds of the next financial crisis could be sown now as anticipated shortages compromise the quality of collateral financial institutions are willing to accept.

A survey conducted by SIX Securities Services has found more than 35% of participating financial institutions would accept lower-quality collateral as long as it was cheap.

“There is something of a collateral paradox in the results we have seen from our survey,” says Robert Almanas, managing director for international services at SIX. “More than one-third of people think it is acceptable that collateral is of low quality, complex and opaque as long as it is cheap, but 43% think collateral should be simple, high quality, liquid and easy to value.

“That view is not necessarily reconciled with the first view. Additionally, 57% think the price of collateral is more important than its quality.”

Putting all this together, says Almanas, reveals a paradox – people acknowledge collateral should be high quality, but low cost takes precedent.

The post-trade services provider surveyed 60 buy-side and sell-side firms in the UK, France and Germany during December. A majority of respondents (53%) said high-grade collateral would rise in cost by about 9% by 2015.

Worryingly, 48% agreed securitizing and repackaging existing portfolios to create new collateral pools will result in additional risk and sow seeds for the next crisis.

“Regardless of what regulators require, collateral should be simple, high quality, liquid and easy to value,” says Almanas. “Part of the shock to the financial system in 2008 to 2009 was that repackaged securities were difficult to understand and value, and that some had not been valued for a long period of time.

“We hear people suggesting that a solution to the collateral shortfall will be via repackaged securities – we don’t want to go back there.”

Almanas says he is not convinced that there is enough quality collateral to keep the capital markets functioning, not just as efficiently as possible but also in a safer manner. Repackaging lower-quality, existing securities that are readily available is not the solution, he warns.

Financial industry analyst Celent estimates it will cost the financial industry more than $53 billion in infrastructure and technology investments to achieve collateral and operational efficiency. Unsurprisingly, plenty of firms, including SIX, are lining up to offer services.

In May, central securities depositories (CSDs) Euroclear and Depository Trust & Clearing Corp (DTCC) signed a memorandum of understanding to create a joint collateral processing service. It is planned the service will offer automated transfer and segregation of collateral based on agreed margin calls for OTC derivatives and other collateralized contracts.

Euroclear and DTCC will also establish mutual links, permitting firms to manage collateral held at both firms’ depositories as a single pool. The joint service will be operated as an industry cooperative and will provide open and non-discriminatory access to all other collateral processing providers, including custodians, CSDs and international CSDs, that wish to link their services to the joint service.

In the same month, Clearstream and BNP Paribas Securities Services announced that their jointly developed collateral management service had been launched across multiple markets for fixed income and equities.

The service enables mutual customers to use Clearstream’s global collateral allocation, optimization and exposure coverage while BNP remains the local custodian, managing local settlement and asset servicing for its clients.

Clearstream has also entered into partnership with Spanish CSD Iberclear to develop a tri-party collateral management service for the Spanish market. The service will collateralize the exposures in the Spanish market of Iberclear’s clients.

Collaboration is a route that SIX envisages as well. Almanas believes the solution lies in collateral sourcing. “In its current state, collateral is fragmented across different locations,” he says. “We are working to give our customers access to global collateral pools to enable our clients to get access to their collateral – and that collateral can move as seamlessly as possible.”

This will be possible via collaboration with other collateral managers and providers, which is opposite to the traditional approach where organizations offered optimization services only if the customer handed over all of their collateral.

“This is an obsolete approach because in these risk-averse times, clients worry about concentration risk,” says Almanas.

While standards of quality are being set for collateral by regulations such as Dodd-Frank and EMIR, it is in the area of collateral obligations with counterparties and other types of transactions that problems might occur, says Almanas. “There is a finite pot of collateral, and the high-quality collateral will go to where standards are being set.”

However, the feared shortfall in collateral globally might not be as severe as first thought. The moves to T+2 settlement in Europe and in the US – where T+1 also is being mooted – will help to free up collateral and enable it to flow more easily.