The Collateral Cure for Cash
A key lesson drawn from the ongoing financial crisis is that unsecured risk-taking, which used to be a common way to turn a profit, is an ailing patient. While there is no holistic cure to rid the capital markets of its current ills, managing risks by collateralising transactions to back up exposures is a timely tonic.
The notion of a financial institution being ‘too big to fail’ has been quashed by recent events, which have radically altered the landscape for investment and commercial banks. Last year, a series of shocking incidents set the alarm bells ringing – Bear Stearns’ emergency acquisition by JPMorgan and the collapse of Lehman Brothers are two example. The biggest moral from these events is that the default of a major global bank can no longer be considered as just theoretical. These episodes triggered a meltdown that severely disrupted the term deposit, credit derivatives and commercial paper markets. It also forced treasury managers to re-think their short-term cash investment strategies.
Retail and institutional investors have since become more concerned about the financial strength of the organisations with which they invest and hold cash positions. As confidence in the financial sector has waned, treasury managers are faced with two possibilities. One involves shunning the cash markets entirely and putting funds into high-grade treasury bills or government paper, in a sense a flight to quality but at the expense of yields. An alternative is to enter into collateralised deals, such as repos, in the secured markets where an attractive risk/reward balance can still be attained.
While many treasury managers have not considered the use of securities as collateral when planning their short-term cash investments, opting instead for the ease of cash time deposits, more and more are investing their cash in the short-term repo markets as a secure alternative. Treasury managers are now realising the safety benefits that collateralised repo lending can bring, as well as the higher yields and greater flexibility it offers. Treasurers are protected against counterparty default in a repo transaction because they are able to sell securities they receive as collateral to recover their cash position in the event of the counterparty defaulting.
To achieve a low level of risk, treasurers investing in repos will need to carefully select their counterparties and define the categories of collateral they are willing to accept. But this is not enough. Cash investors also need to protect themselves against a sudden drop in the value of the assets received as collateral. This is why most repo transactions are over collateralised, the percentage of which is agreed by both counterparties.
Also, to avoid being overexposed to a particular sector or issuer, collateral concentration limits are defined by the cash investor, which forces portfolio diversification. All these factors are essential to fully leverage the benefits of using collateral for risk mitigation. But, collateral needs to be managed. There are experts, known as triparty agents, to which all collateral management and administrative functions can be outsourced. For those treasurers that may not be equipped with the necessary expertise or IT infrastructure to manage this process themselves, triparty agents are indispensible.
Outsourcing collateral management duties to a neutral triparty agent is an easy and natural way for treasurers to benefit from sophisticated risk-mitigation mechanisms that they may not have themselves, but are implicit in collateralised lending. For example, a triparty agent will assume operational control over all aspects of the collateralised transaction, i.e. the agent executes daily mark-to-market and margin checks, adheres to pre-determined collateral concentration limits and performs collateral substitutions to ensure that the right collateral is in use at all times. This process is entirely automated, including the reporting of collateral values and movements to both counterparties.
Accessing an established triparty agent is possible on an indirect or direct basis. For example, a treasurer can access a triparty agent through an intermediary bank with which it already has a relationship. The banks often offer access to an independent triparty collateral management provider or a firm can seek direct access to the triparty agent.
A triparty repo transaction can run for one day or up to a year or more in a term repo, depending upon the needs of the two counterparties. Triparty agents, therefore, are flexible and able to cater for the short and long-term needs of the treasury community.
Risk management and mitigation will continue as prevailing themes, which is why the considered use of securities as collateral when lending cash in triparty is key to generating returns in a safe environment. Treasurers define the collateral acceptance criteria with the highest levels of granularity that best meet their own unique risk appetite. Triparty agents can ease the collateral administration burdens of both counterparties, allowing treasurers to focus on non-operational business priorities, while keeping fully informed of the transaction’s status. The simplicity of lending cash in a short-term reverse repo using repo is comparable to making a straightforward time deposit.
As our markets splutter back into life, it becomes even more critical that the lifeblood of our capital markets – liquidity – continues to flow without inhibitors. Treasurers may find it useful and timely to consider how best to preserve liquidity through alternative means. Lending cash in an environment that collateralises exposures and reduces risk seems sensible, if not an imperative, during extraordinary market conditions.