Collateral transformation will entrench too big to fail
Global banking regulators have placed the risk-absorbing capacity of government bonds at the centre of their brave new financial world, ostensibly opening up revenue opportunities for banks in collateral-transformation for OTC purposes.
However, regulations and high barriers to entry suggest financial institutions face an uphill battle to generate returns while regulators are unwittingly exacerbating the concentration of risk.
By asking derivatives-markets participants to post collateral with counterparties for both cleared and uncleared transactions, and before and during the life of a transaction, the new rules have ramped up demand for a scarce resource and, perhaps unintentionally, created a business opportunity for players able to source high-quality collateral and deliver it to clients who need it.
Some banks have highlighted collateral transformation, or the process of receiving relatively low-quality assets and delivering government or agency assets, as a potentially attractive source of revenue in the Dodd-Frank/Emir era.
For instance, a US bank this year launched a new collateral management service, intended to help its clients optimize their collateral portfolio in the face of regulatory demands, estimating its potential revenues from collateral transformation for OTC purposes at around $500 million per annum.
It seems, however, that regulators are asking too much of the collateral market. Indeed, taken in the context of the Basel III leverage ratio, which will require banks to hold more high-quality collateral on their own balance sheets while at the same time making it harder for them to participate in the repo and securities lending, it’s not clear that more than a handful of banks will be willing or able to provide collateral transformation services for their clients.
“Yes, some banks are seeking to make a margin on performing collateral transformation for clients,” says one former UK regulator. “How appealing it will be, however, depends on how much capital a bank has to hold against the activity.
“The extent to which collateral transformation will work for banks funding their own balance sheets depends on the spread between collateralized and uncollateralized lending.”
According to market sources, banks with market-leading prime brokerage business that have positioned themselves as client-clearing members during the past two years are emerging as the most likely candidates to prosper in the collateral transformation market.
Prerequisites are relatively large: unconstrained balance sheets, high leverage ratios, a cheap cost of funds and a global franchise that reaches into all corners of the collateral-rich buy side.
With Swiss banks severely curtailing their fixed-income activities, and some of Europe’s leading investment banks struggling to meet the Basel III leverage ratio of 3%, the US bulge bracket are the most likely to focus on the collateral transformation as a revenue driver.
However, even banks with a leverage ratio at the holding-company level might be well above the Basel minimum, and the Federal Deposit Insurance Corporation and Office of the Comptroller of the Currency proposed repo rules could make it difficult for even the biggest balance sheets to offer attractive collateral transformation services for two reasons.
First, the proposals would force banks to hold more collateral against on- and off-balance sheet repo trades, limiting its availability to collateral transformation clients. Secondly, regulations that limit repo will limit the market place for transformation, as it’s essentially via repo and the related securities lending that the transformation of low- for high-quality collateral is achieved.
Moreover, it would seem that regulations that incentivize dealers to provide collateral to clients, who will then use it as margin with central clearing counterparties (CCPs), risk increasing interconnectedness between derivatives-market counterparties rather than decreasing it.
“The only players that can release collateral in bulk without disrupting the repo rate are the banks,” says one market source. “But you won’t reduce interconnectedness by requiring banks to add another level of regulatory intermediation with CCPs – you will increase it.”
With the overarching ambition of capital and derivatives regulation in the west apparently to seek a substantial reduction in the size of bank balance sheets and OTC derivatives markets, non-US institutions and markets are likely to emerge as alternative providers and liquidity venues.
While the Washington lobby exerts its not-inconsiderable muscle in diluting Dodd-Frank’s definition of US-persons, expect Asia to take up a lot of the slack in OTC activities, including collateral transformation. Just don’t call it regulatory arbitrage.