Collateral Management: Is Access Really King?

When it comes to managing collateral, fund managers can just forget about all the doomsday talk of a shortfall.

There is enough to go around — and to fulfill a multitude of regulatory requirements — if only it could be easier to access it.

Or so says a new study supported by the US Depository Trust & Clearing Corp. (DTCC). Conducted by the London School of Economics and Political Science (LSE), the study entitled “The Economics of Collateral” blames silos for making the flow of collateral more difficult for market players seeking newer sources.

“This limited access to collateral can be attributed to regional and product focused market infrastructure, varying regulatory policies across markets, fragmentation at firm levels and across local jurisdictions and CCP [central clearinghouse] product specialization,” says the report.

Break down the silos and et voilà the free flow of collateral emerges. Sounds great in theory, but fund managers contacted by FinOps Report say the report’s suggested solution of global pooling a collateral sounds a bit utopian. “Just when did DTCC agree there was no collateral shortfall to worry about?” queries one collateral management specialist. In fact, the new DTCC-backed report has popped up only six months after DTCC published its own report entitled “Trends, Risks and Opportunities in Collateral Management,” warning of a major global collateral shortfall as market players face a staggering 1,000 percent potential increase in margin calls due to new regulatory requirements.

In a press statement discussing the LSE report, the DTCC cites an earlier study released by the International Capital Market Association, the influential London-based trade group for global investment banks and asset managers in London, which flagged the negative impact that decreased collateral mobility could have on the stability and efficiency of capital markets. The report, entitled “Collateral is the New Cash,” warned of higher borrowing costs for governments, increased funding costs for corporates and increased risk for pension plans and other institutional investors.

A rationale for DTCC’s evolving stance can be found in the recommendation made by the LSE report’s co-authors: cooperaton among infrastructure providers could relieve the collateral logjam. “The search for new methods to alleviate bottlenecks and seamlessly allocate collateral is the next challenge for infrastructure providers and participants,” writes co-author Professor Ronald Anderson at the London School of Economics. “Collaboration between participants and infrastructure providers will be crucial to ensuring a seamless process.”

These ideas were foreshadowed in the earlier DTCC report which concluded with these sentences: “The complexity and global nature of the derivatives market have seen market participants express a preference for an industry-wide strategic solution to address the challenges related to collateral in a more holistic manner to avoid costly fragmentation. Toward that end, DTCC is continuing to collaborate with industry partners to develop solutions that address the operational costs and risks associated with the increased demand for collateral.”

DTCC’s business strategy obviously fits well with both the locally alarmist and globally visionary points of view. It is no coincidence that DTCC and international securities depository Euroclear last year signed a memorandum of understanding to eventually manage their collateral pools as though they were a single pool.  As explained in May 2013, Euroclear would eventually allow members of Depository Trust Company, the DTCC’s depository subsidiary, access to collateral it holds through Euroclear’s own Collateral Highway service, and DTC would permit members of Euroclear access to the collateral held through its planned Margin Transit Utility. The venture, to start off in the US, would initially offer automatic transfer and segregation of collateral based on agreed margin calls for over-the-counter derivative contracts and other collateralized deals.

Neither DTCC nor Euroclear officials were available by press time to comment on the progress of of their collateral agreement or the findings of the LSE-written white paper, but the consensus of five collateral management specialists in the US and five European asset management shops reading the analysis is telling.  The word used by many, and the apparent sentiment of all of them was simply “interesting.”

If their collective reaction sounds non-committal, it is with good reason. The question of how to manage collateral has been a concern in financial circles for the past several years, heightened by a slew of new regulatory requirements which all come down to higher collateral requirements and more deals requiring backing. Whether or not they believe the numerous industry studies predicting collateral shortfall to varying degrees, fund managers can hardly afford to be blindsided if and when the crunch arrives. If they don’t have sufficient collateral on their own, they must find it elsewhere. That elsewhere is typically in the hands of their broker-dealers and custodian banks, who are members of securities depositories, such as DTC and Euroclear. If those participants don’t help out, fund managers are in a bind.

Until recently that was all they could do, other than put up or raise cash on cost-prohibitive terms. Enter the brave new world of collateral mobility. Euroclear’s Collateral Highway already allows clients of custodians BNP Paribas, Standard Chartered and Citi to use securities held at one of those banks or Euroclear to back any transaction for which Euroclear serves as the triparty agent. The DTCC-Euroclear hookup would take that scenario a step further with other custodians, depositories or even international securities depositories, such as Clearstream, allowed to join the “open service” or industry cooperative and include the collateral on their books as part of the international pool.

Because fund managers are not direct members of depositories, they can only hope that they will benefit from the trickle-down availability of pooled collateral. If their broker-dealers and custodians gain access to more collateral, they can help out their fund manager customers by providing them with collateral far faster and hopefully more cheaply. Collateral mobility presumably helps with the process of collateral optimization — the best use of existing collateral –and might even reduce the need for collateral transformation — the exchange of a lower type of collateral for higher-quality collateral. That’s the tune the depositories and largest custodians — heavily promoting their collateral management services — are now playing.

Fund managers are hopeful, but questioning the details. “Will it [the new collateral paradigm] cut our fees, or just give us more insight into where the collateral is located and how quickly we can access it?,” questions one collateral management expert at a New York fund management shop.

The first result would be great, the second satisfactory, and combined make for an ideal scenario. But as is often the case with change — especially when regulation is driving it — there is no free lunch. Fund managers might wait to break out the champagne until they see how it plays out with their service providers. Although faced with inevitably more collateral usage,  they have no guarantee that the benefits of scale in the collateral pool will include volume pricing.

“Fund managers will definitely operationally benefit from having more sources of collateral, but they might end up with the same financing charges depending on what their custodians and broker-dealers offer,” says Bjorn Schumburg, senior consultant with investment operations specialist SimCorp in North America.