It seems to me [market participants] havent realised that the quality of collateral posted is going to need to be better under the new regulations," said Jamie Lake, managing consultant at GreySpark Partners at a press briefing on Tuesday. "Theres going to be a higher demand for high-quality collateral, such as cash, at a time when good collateral is scarce.
GreySpark surveyed a number of organisations across the industry including hedge funds, brokers and asset managers, on both the buy-side and sell-side on their opinions regarding regulations that included European Market Infrastructure Regulation, Markets in Financial Instruments Directive II and Basel III.
The common consensus was that the impact of these regulations on liquidity risk was to be positive, with more than 75% of respondents indicating they believed liquidity risk would decrease in response to upcoming regulation.
If these regulations do have the effect of leaving some market participants with a shortage of collateral for use with clearing houses, some institutions will be able to take advantage and generate profits through collateral transformation, which is the process of converting non-eligible collateral into eligible collateral.
This takes the form of a clearing house member, generally large banks, receiving non-eligible collateral from a client, converting it into cash via repo and posting that cash with the CCP as collateral, which has been highlighted as neatly circumventing regulations on collateral quality.
You can expect to see better-organised investment banks try to make money out of collateral transformation, says Lake.
Misunderstanding of the potential effects of regulation could be linked to sentiment in the markets that guidance from regulators has been rather lacking, according to the GreySpark survey. In the report, no respondents characterised the level of guidance given by regulators as any better than average, with 34% of respondents deeming it to be insufficient.
The lack of guidance from regulators is also reflected in the lack of action taken by market participants in preparation for new regulations.
Until regulators give more details, theres unlikely to be much change," says Lake. "Regulators havent cottoned on to the fact that they need to be more prescriptive: theyve traditionally taken a reactive approach, but now the industry wants to see a more proactive stance."