In addition to optimization, several providers have begun offering transformation, whereby lower-grade assets can be upgraded to eligible assets via the securities lending and repo markets. “Looking at the competitive landscape, there’s a lot of different players along the line that can provide value and that are trying to provide value,” says Northern Trust’s Satten.
Firms that choose not to use an in-house system and/or go through their dealers for collateral transformation can also outsource these functions, which is where custodians are stepping in to offer collateral management services powered by a combination of proprietary platforms and third-party vendor solutions. This trend is likely to grow, as 66% of custodians surveyed by Sapient said they either intend to, or already offer, some collateral transformation services. The difference in a custodian “being able to offer an overarching suite of middle-office administration and custodial services is that we’re able to act as what I would call the ‘ultimate middleman’ in that we’re able to see and provide support across middleware, across FCMs, across trade repositories, and across regulatory regimes, so as to support the client holistically and globally in a manner in which I’m not sure other entity types are able to do,” says Satten.
Outside of these services, the collateral challenge could also be alleviated by central bank action. “Since regulation and the activities of some central banks has led to a decrease in collateral velocity, they may be forced to come up with schemes like a reverse repo facility that provides collateral in different parts of the world,” says the IMF’s Singh. “They will look at the issue differently, but the fact that you have the reverse repo facility from the Fed and the Reserve Bank of Australia’s contingent liquidity facility tells you that they have acknowledged that, if need be, they will supply collateral or will do something so that the need for collateral or high quality liquid assets will be taken care of.”
These facilities, however, disintermediate what Singh calls the ‘financial plumbing’, in which dealer banks sit in the middle between banks and non-banks in order to move collateral and cash between them. “A reverse repo program allows non-banks such as money market funds to come in and get collateralized funding. If you do this in large size, you will rust the plumbing pipes that go between banks and nonbanks,” he says. If the collateral demand is phased out over a few years, perhaps the system will take care of itself, says Singh, but if the collateral demand comes all at once over the next year, there could be potential risks. “If indeed this is not phased out and there’s an impending need in the next year, you will find a reduction in some markets like OTC derivatives,” he says. “To get a hand on good collateral, it might be too high a price, or the bank balance sheet space may not be there for collateral transformation. There’s always a price for which you can get your hands on some good quality collateral. The question is, in a zero rate environment, when you’re hardly making any returns, do you want to spend another 30-60 basis points trying to get high quality liquid assets? I don’t know. If you’re in a normal yield curve where returns are 6-7% you don’t mind spending 30-60 bps. But when you’re making zero to 200 bps, you may just cut corners and not hedge, or not do derivatives and do hedges via futures [instead].”
Although quantitative easing may have had positive macro-economic effects, its adverse effect is that it takes up balance sheet space at large banks, as non-banks deposit the cash coming from the Federal Reserve.
“The balance sheet at the large banks is not as freely available as it was five or six years ago, and you need that balance sheet space to move that collateral around, to do collateral transformation, etc. And it may not be worth your while to do it for a small client,” says Singh. “If the smaller players don’t get the collateral and don’t use OTC derivatives and go to futures or don’t hedge, you’re not removing risk. The whole idea was to make the system safer. If you go through CCPs, you need collateral. Well, to get collateral you need to go to the same 10-15 banks who are adept at doing collateral transformation. So, in a very ironic way, the same CCPs which you thought were safe houses, in order to get there, you’re making the system more interconnected, because you need the 10-15 banks who do the collateral transformation. So we may be back to square one.”