The Collateral Crunch
The development of a secured money market in Europe is well on its way, but the pools of collateral may be drying up quicker than they can be replenished due to continuously growing demand. Firms are now seeking new, innovative ways to use and re-use their collateral, including that which they receive from their trading counterparties.
Collateralising transactions is one of the most important risk mitigation techniques used in Europe’s capital markets. Institutions employ collateral in three main areas: securities financing (including securities lending and repos), derivatives trading and to support liquidity needs (e.g. for euro system credit operations or intra-day transaction settlement).
Over the last decade, the use of collateral in wholesale financial markets has exploded across all three segments. The latest International Capital Markets Association (ICMA) survey puts the total outstanding in the European repo market at around €6 trillion – an astonishing boom given that we can only really talk of a repo market in Europe as of the late 1980s. However, as with most growing markets, there may come a point in time when demand outstrips supply leading to concerns about the collateral crunch.
The driving forces behind the phenomenal growth in demand for collateral are twofold: legislative incentives and organic growth, with new counterparties insisting on secured investments, and borrowers increasing their appetite to finance.
Two regulatory regimes are central to the trend: the Basel II Accord and implementation of the EU Collateral Directive. The former has prescribed minimum balance sheet capital requirements for banks to support their credit exposures. Credit exposures that remain unsecured will be penalised with greater capital requirements while capital requirements for secured exposures will be minimised.
The goal of the Collateral Directive, already implemented in domestic jurisdictions throughout the EU, was to create a uniform legal framework to limit legal risk in the provision of securities and cash as collateral. The creation of a clear, uniform pan-EU legal framework for the use of collateral contributes to the greater integration and cost-efficiency of Europe’s financial markets. Furthermore, its harmonised collateral rules are designed to remedy legal uncertainty while at the same time stimulate cross-border transactions and inter-European competitiveness.
The collateral most commonly used by the market to cover exposures are instruments with intrinsically low credit and liquidity risks, namely government securities, high-grade corporate bonds and obviously cash. As interest rates rise, cash may become an expensive form of collateral. In addition, collateral managers anticipate that, under the new Basel II framework, use of lower rated collateral will become more expensive in the calculation of adequate exposure coverage. With the growth of secured transactions showing no sign of abating, obtaining the right sort of collateral is paramount; high-quality government bonds will be in even greater demand.
Under a tri-party collateral management agreement, the securities used as collateral are not specified, but are allocated by a neutral tri-party agent based upon a pre-defined set of rules and criteria agreed by both counterparties.
In the current tri-party environment, when collateral is delivered from the dealer’s account to its cash lending counterparty, it remains in the cash lender’s tri-party account with limited opportunities for them to re-use the collateral received. However, this provides the dealer with securities substitution capabilities throughout the duration of the agreement and fully integrates its trading and financing activities.
To exploit the full potential of the securities they receive as collateral, particularly high-quality collateral, an ever-increasing number of our clients are looking to re-use the collateral they receive from one trading party as collateral to cover an exposure they have with another. Re-using collateral, while maintaining securities substitution capabilities for the initial collateral giver, will be possible with the collateral re-use function that Euroclear bank will launch in early 2007.
The market’s financing needs have not yet reached their peak. The European repo market, for example, continues to post healthy year-on-year volume increases. For this to continue, money managers need to optimise the use of the collateral they receive. Working with service providers that can facilitate re-use or re-hypothecation of collateral can help to generate new, innovative and accessible sources of collateral.