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LCH.Clearnet defends bonds and gold as margin collateral

The clearing house’s head of risk management explains the group’s actions in accepting Kreditanstalt für Wiederaufbau bonds and gold bullion into its alternative margin collateral payment repertoire.


Clearing house LCH.Clearnet has defended its alternative margin collateral payment repertoire, after revealing on Thursday it is now accepting benchmark bonds issued by Kreditanstalt für Wiederaufbau (KfW) from November 1 as part of margin collateral, in its latest step to broaden the way that groups cover themselves. It comes only two weeks after the company announced it would accept gold bullion as collateral.

“Our overriding principle is to make markets safer,” says Chris Jones, executive director and head of risk management at LCH.Clearnet. ”Whilst we hope to gain business over the next few years, this is not a race to the bottom and we will not compromise our risk management.”

The new KfW bond initiative is said to be worth approximately €150 billion of eligible securities to be pledged as initial margin. Debt securities issued by KfW have been backed by the explicit, direct and unconditional guarantee of the Federal Republic of Germany since 1998, and are considered to be of the highest credit quality, rated AAA by all three major agencies, with a stable outlook.

Recently, LCH.Clearnet revealed it would also extend the range of eligible collateral types to include gold bullion by the end of the month, subject to final regulatory approval.

In accepting gold as cover for margin liability, LCH.Clearnet will be expanding the choice for margin collateral, which is considerably attractive for financial institutions as a way of keeping their capital requirement levels well above compliance demands.

LCH.Clearnet says the initiative is supported by the World Gold Council, which recently submitted evidence to the Basel Committee for gold to be included in banks’ tier 1 assets by European banking regulators, recognising gold’s growing relevance as a high-quality liquid asset.

“When considering the types of assets we would accept as initial margin collateral, we look at those that, in the event of a default, we could sell into the market at sensible price,” says Jones. “We want to deliver more flexibility and choice to clients, whilst maintaining high standards of risk management.”

Gold prices are notoriously volatile but usually do become safe havens when equity markets act violently. Gold is around the $1,600 mark, whereas in mid August it had been steadily rising until some market participants forecast a breach of the $2,000 level by the end of the year.

When asked whether accepting gold as collateral was a risky way of covering credit risk, Jones revealed there were appropriate and conservative barriers in place.

“If you look at the detail on how we accept gold as collateral, we set haircuts and limits to address price and liquidity aspects,” says Jones. “We have been very prudent in the structuring of this.”

Euromoney asked Jones what would happen if, in the event of a counterparty default, LCH.Clearnet had to sell the gold used as collateral back into the market, but prices were low compared to when it was first used as collateral. Jones says that historically in volatile markets, gold prices usually rise, and that the amount of gold that is allowed to be used as collateral will not be an amount that would risk covering the member’s position.

Margin collateral is the amount – somewhat like a deposit – the holder of a financial instrument (member of the clearing house) has to post to the clearing party to cover all or some of the credit risk it holds and its position should it default.

Meanwhile, under a raft of sweeping regulation changes across the US and Europe, it is now mandatory to clear all over-the-counter derivatives through a central counterparty (CCP) clearer. This spans across all asset classes, despite market dynamics and end-users varying from sector to product in a broad way.

Since the credit crisis and the demise of Lehman Brothers in 2008, counterparty credit worthiness has remained one of the main concerns for financial markets. Clearing houses have since delivered tighter controls and heftier collateral requirements to cover the risk of each clearing member.

In some cases, there have been serious concerns that some end-users, mainly in the energy and commodities arena, are unable to afford high margin calls, which would prevent them from trading, and therefore clearing derivatives needed to hedge their everyday positions.

In this case, liens – in other words, an IOU – were accepted as collateral. However, it has since changed and end-users will now need to deliver cash, which is said to take away from non-financial institutional groups’ capital.

In terms of other forms of collateral, LCH.Clearnet says that it is considering corporate bonds as margin collateral and reveals there are talks about other asset classes.

“We are continuing to look at other forms of collateral and there’s work under way to introduce new forms of acceptable assets that provide that flexibility but meet our rigorous risk-management standards,” says Jones. “We are looking at corporate bonds as a form of collateral, as our clearing offering expands, and listening to what our clients would like to see accepted. Again, we look at whether we can accept these in a way that is consistent from a risk-management perspective.”

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