A Cool Dip In The Collateral Pool

The fireworks have come and gone. The United States won its third Women's World Cup (thanks in large part to Philadelphia area native and proud Eagles fan Carli Lloyd).

So now it's onto the traditional part of the summer when Manhattan's financial district seems curiously half-populated for about six weeks as everyone tries desparately to escape the city and its humidity.

Perhaps my brain is already half-fried — or it was the mention of pools — but the July heat got me thinking this week as I read Marina Daras' final feature for Waters, taking a look at European efforts around autocollateralization.

Collateral management has been a huge issue on the buy side for several years now: given new constraints on how firms can collateralize trades, the limited ability of banks to provide assistance, and the relative scarcity of high-quality inventory with which to do it on one's own, it's become a crucial matter to get right. The days of an easy tri-party repo are pretty much gone. And for once, the buy and sell sides both recognize this, with securities services arms up and down the Street now actively preaching engagement and marketing their latest wares.

At Waters, we've published a number of features about the topic of late, covering matters far and wide ranging from managing asset rehypothecation, to identifying the proper moment to optimize, and building and implementing netting algos.

Collateral management has been a huge issue on the buy side for several years now: given new constraints on how firms can collateralize trades, the limited ability of banks to provide assistance, and the relative scarcity of high-quality inventory with which to do it on one's own, it's become a crucial matter to get right. The days of an easy tri-party repo are pretty much gone.

Velocity & Enforcement

The latest perspective from Marina's story tackles the problem of borders. In Europe, for example, despite the great strides certain providers are making on the downstream use of technology to rapidly match collateral with counterparties at the point of trade and optimize use of clients' supply, there remains much work to be done further upstream as national settlement takes place and supranational monitoring becomes required.

Quoting from a passage in a European Commission green paper on capital markets union published this spring, Marina wrote: "With demand for collateral rising, there are risks that the same securities are being reused to support multiple transactions as was the case pre-crisis and work is underway internationally to look at these issues."

Indeed, that would certainly negate the point of collateralization, wouldn't it? The most interesting part of any green paper, though, comes in the public comments, and in this case, they didn't disappoint.

I'd recommend a peek at all of them, but here are just a few assorted responses to Questions 26.1 and 27.1, opinions which deal with the prospect and potential risks of greater cross-border collateral movement, and the need to coordinate the way various jurisdictions' legal systems deal with these assets.

Suffices to say, they are quite varied and bring up a host of different issues (bold added for emphasis):

"The absence of an effective collateral enforcement system is among the most serious barriers to the development of the corporate bond market."

"... BNY Mellon sees potential AIF/UCITS segregation requirements as being examples of a broader regulatory trend across multiple pieces of legislation that imposes restrictions on the use of collateral management services, and in particular that favours the provision of collateral management services at the level of core infrastructure, and correspondingly disadvantages the provision of collateral management services at other levels of the custody chain. BNY Mellon sees these trends both as reducing the overall fluidity of collateral, and also as imposing particular problems on buy-side market participants, as buy-side firms very often do not have direct access to the collateral management services of core infrastructure ..."

"I doubt if there is the political will to accept standardisation in this area, so any effort to do so is likely to be a waste of time."

"Haircuts, fluctuating pools of eligible collateral, collateral velocity and the marking to market of collateral assets are responsible for the additional procyclicality and interconnectedness of the financial system. In order for an improved cross-border flow of collateral not to create additional risks, we need to address these issues: first, general collateral must be truly safe this time and less vulnerable to investor confidence evaporating quickly. Secondly several proposals have been put forward to reduce the procyclicality and interconnectedness of collateral such as introducing minimum haircut floors, capping the re-use of collateral and linking deposit guarantee schemes premiums to the use of securities financing. More generally, while collateralised funding can be extremely useful at times of stress when trust disappears, it would be unhealthy in our view to strengthen its central role in our financial system and make it the new norm."

And my personal favorite, regarding 27.1:

"This question is frightening!"

So, perhaps it's the case that while collateralization processes are maturing in the US, they've still got a fair way to travel on the other side of the Atlantic before catching up.

To anyone following these types of matters over recent years, that will come as little surprise. But it's a good reminder just the same: the heat is on, and getting this crucial part of the post-crisis landscape right takes time.