Dealers and custodians are preparing to offer collateral transformation services to help members of the buyside deal with the liquidity and operational burdens of posting variation margin for their over-the-counter derivatives trades cleared through central counterparties.
“Two cottage industries will probably spring up around CCPs. Firstly, custodians are in a great position to turn client securities they hold into cash to use as variation margin for a small fee,” said Richard Prager, head of fixed income trading at BlackRock in New York. “Then for the more leveraged accounts, prime brokers can provide the same service using Var-based models.”
Collateral transformation will present risks as well as revenues for service providers, both in terms of the operational burdens of managing margin postings and being relied on to provide liquidity in volatile markets. The evolution of this service appears inevitable, though, with regulators seemingly unwilling to grant widespread exemptions from buyside clearing. As a result, many more firms will have to grapple with the realities of posting cash collateral in a range of currencies on a daily basis, making margin efficiency into a new industry mantra.
“If a firm is margin efficient it will be able to limit the drag on returns, based on it having to set aside less margin, or using other securities it owns to provide collateral,” said Ray Kahn, head of OTC clearing at Barclays Capital in New York. “In the coming years, being margin efficient is going to be one of the biggest trademarks of all firms.”
A key issue centres on variation margin – collateral posted daily to reflect the mark-to-market fluctuation in the value of a trade – which must be cash. However, some buyside firms may not have excess cash to post, meaning they will either have to convert assets into cash through private financing markets or pay for help.
“The emerging industry view seems to be that some clients will want collateral transformation bundled into the clearing service provided by a dealer as a one-stop shop, while others will want to manage it themselves,” said Michael Clarke, co-chair of the ISDA collateral steering committee and global head of counterparty risk operations and market infrastructure at UBS.
A client can either post securities it already holds to its clearing broker, who converts them into variation margin and posts up to the CCP, tap financing markets themselves, or turn to custodian banks that hold their assets.
“Custodians will be well placed to help buyside clients with their increased financing requirement, as they see the cash pool across a client’s entire portfolio,” said Stephen Ingle, head of product research and development at BNY Mellon Asset Servicing in London. “The cost of providing that service will depend on the risk/return analysis and we’ll have to see who is best placed to provide that, whether it’s prime brokers, custodians or a third party repo desk.”
For their part, dealers are unlikely to offer a bottomless pit of financing given the cost of balance sheet nowadays. “One of the biggest problems with transforming assets into cash is that it uses balance sheet,” said Chris Hansen, global head of dbClear, client clearing at Deutsche Bank in London.”Given the coming constraints on capital including Basel III, we need to price that balance sheet usage appropriately.”
Dealers would also have to be mindful of market risk. Most collateral upgrades will likely involve the dealer executing a form of repo on behalf of the client, meaning dealers will have to exercise judgement over what collateral they accept.
“Including repo and collateral upgrades expands the need for additional risk management parameters of the client clearing business. We are examining that in a sophisticated way, including how much and what types of ineligible collateral we are willing to accept,” said Kahn at Barcap.
Late 2008 saw many repo markets seize up, securities lending haircuts hiked and collateral criteria tightened. Such a scenario could significantly impede access to liquidity for more leveraged buyside firms needing to meet margin calls.
“I’m not concerned, because I’m not looking for leverage. But it is true that once markets get choppy, haircuts change, costs are increased, and those that rely on leverage find its not available at the time they most need it,” said Prager at BlackRock.
As a result, UBS’ Clarke argues firms will have to plan ahead for liquidity squeezes. “This requires all firms to think about liquidity management more keenly,” he said.
“Market participants will have to model the collateral they might have to post going forward under a variety of circumstances. To be prudent, this may lead to holding a proportion of assets in a liquid form eligible at any CCP without the need for transformation”