8. The Collateral Infrastructures
- Manmohan Singh
- Published Date:
- October 2016
This chapter will cover some of the major challenges for an efficient global financial system, including the mobilisation of eligible collateral across a fragmented global infrastructure and the role of global custodians. The chapter describes how the market has entered into a new collateral paradigm that requires a structured, cohesive approach both internally within financial institutions and externally across the global financial system. In keeping with the theme of this book, this chapter can be viewed through the lens of collateral and how the custodians will impact the plumbing in the future.
The overall goal of the numerous regulatory initiatives is to make the global financial market more resilient against systemic risk. Since 2008, regulators have acknowledged the importance of collateral and, in some jurisdictions, have addressed its shortage. Regulations recognise that collateral lubrication is essential to financial plumbing and have chosen to use practical methodologies (eg, netting of repos under certain conditions), although the leverage ratio will still be a binding constraint. The primary driver has been the continued shift from non-collateralised (unsecured) to collateralised (secured) transactions as well as an overall enhancement of transparency.
As we saw in Chapter 7, every institution or market is different, with a lot of friction in the pipes, and collateral can get “stuck”. Furthermore, some friction is intentional, where the client does not want to rehypothecate collateral. In aggregate, the friction can be considerable and may be another reason why the theoretical balances do not always add up mathematically. Regulators have increased the importance of robust collateral management to help control and reduce perceived weaknesses in the global financial system, in particular in periods of stress. There have been significant new collateral-related regulatory changes in key areas of liquidity risk management: the introduction of mandatory central clearing and of initial margin for non-cleared bilateral transactions; margin calculations; inventory management; reporting; portfolio reconciliations; and resolution (Figure 8.1).
Figure 8.1The Changing Collateral Paradigm
Complying with the new regulatory changes has elevated the topic of collateral to the forefront of market participants’ agendas. Effective collateral management and efficient utilisation of collateral have become prerequisites for broader regulatory compliance and commercial success in financial services. These high-level regulatory requirements have had an impact on the fundamental approach to collateral issues and the costs associated with them. The question of sufficiency of supply of eligible collateral to fill the required new demand is ongoing, but what can be clearly seen is the reduced access to the custodial balances. Many institutional lenders have curtailed their lending activity or have shortened the term of the transactions in line with the liquidity coverage ratio (LCR). It has redefined collateral management functions and brought a more centralised approach within financial institutions and across their various functional areas including trading, credit and market risk, and treasury and legal operations.
The disconnect in the secured-financing market has been a key factor in why central banks have moved into this space to act as intermediaries until markets stabilise. At present, any central bank within the Eurosystem can take eligible collateral issued within the eurozone. Thus, a German bank can use Spanish, French or Belgium debt as collateral and the Bundesbank will allocate cash to the entity depositing it. The Eurosystem relies on two mechanisms to receive collateral on a cross-border basis: eligibility across central security depositories (CSDs) and links to its correspondent central banking model (CCBM). The aim is to bring greater access to a wider pool of collateral issued in the eurozone; facilitate interoperability/netting with the central banks; and encourage more borrowing directly with and between central banks via the CCBM. Similarly, the Fed in the US continues its trial programme of reverse repo to support long-term plans for implementation of monetary policy (see Chapter 4), and, as a by-product, this will also supply collateral to meet the increasing demand from new regulations.
The major changes are:
❑ Higher demand in high-quality liquid collateral: Eligible collateral can be split into high-quality liquid assets (HQLAs), which comply with the Basel III liquidity ratio (LCR) under Level 1 and Level 2 definitions; and high-quality assets (HQAs), which are normally liquid, investment-grade securities, or cash in the main currencies that allow the flexibility to fulfil collateral requirements, particularly in stress events. Some examples of increased requirements of eligible collateral are: HQLA via LCR to mitigate liquidity risk; mandatory clearing via central counterparty clearing houses to mitigate counterparty risk; the expanded use of secured funding; and the overall trend of the shift from unsecured to secured transactions.
❑ Reduction in the supply of eligible collateral: This could come about by more stringent eligibility criteria on collateral and decreased demand to enter into this market due to stricter capital regimes, low incremental returns, threat of a financial transaction tax, etc.
❑ Lower velocity of eligible collateral: This has an adverse impact on the supply side due to the decreased ability to rehypothecate or reuse unencumbered collateral. This is largely due to the segregation of client collateral as well as collateral pulled out of the system and remaining siloed at CCPs (eg, default funds and/or the limited rehypothecation of initial margin), in central banks (due to quantitative easing), with custodians or in collateral buffers, eg, liquidity asset buffer (see Chapter 2, “Collateral Velocity”).
❑ Increased transparency via reporting: This is required to provide visibility of unencumbered assets (“unencumbered” in this case referring to the ability and the legal right to use securities and cash as collateral), their location, their total market value, the estimated time to mobilise them and the tracking of pledged collateral that has been rehypothecated. This is reflected in the liquidity adequacy framework when intraday liquidity issues are being addressed.
❑ Increased frequency, execution and evidence: This relates to the accurate calculation of margin calls in which the time horizon is shortening from quarterly or monthly to daily or intraday on margin calls – a key area of focus within the Dodd–Frank and European Market Infrastructure Regulation statutes.
❑ A holistic approach: This requires comprehensive data and processes within the collateral space across products, divisions and legal entities to enable appropriate liquidity management during stressed market events – stated within the broad requirements within the Capital Requirements Directive IV’s “Collateral Framework Document”.
Global Market Infrastructure and Custodians
This section focuses on the market participants and their perspectives and the roles they play within the global financial system. As per Risk Management Assocation data (which covers assets in the custody of clients, including pensions, insurers and the official sector, but not hedge funds), about 80% of collateral does not reach financial plumbing and stays with custodians. On the other hand, hedge funds maximise collateral reuse, because collateral is their ingredient for funding and leverage (see Chapter 2), and their interactions with dealers and banks active in the pledged-collateral market leaves little pledged collateral that is not reused.
The sell side (eg, investment banks) needs to have a coordinated approach within the collateral space and has to decide which services it focuses on for its client base. The buy side (such as asset managers, insurance companies) will also need to collateralise its transactions in particular derivatives via CCPs. This means it will have to ensure an ample supply of eligible initial margin and variation margin, or gain access to eligible collateral via collateral transformation trades. This will embrace the custodians and clearers (intermediaries) and financial market infrastructure entities (FMIs) that are part of the multilateral system.
In short, the ideal scenario would be to pledge collateral from one collateral platform to another expeditiously. This would entail cooperation among the main players; different settlement cycles; processing hours due to time-zone differences; market stipulations (prematching/no prematching); and efficiency of the market by increased harmonisation and better cost transparency.
Three major themes have emerged from the regulatory and market response to the financial crises:
❑ Collateral optimisation: This is the cohesive approach to addressing costs, and the availability and allocation of collateral in the most efficient manner and with least impact on finite resources such as capital and the balance sheet.
❑ Accessing collateral: How do we ensure access to the supply of eligible or unencumbered collateral?
❑ Fungibility: This means mobilising collateral across the global financial infrastructure to ensure the supply meets the demand.
The four main providers of triparty repo agent services in the European market are the two international central securities depositories (ICSDs), Euroclear and Clearstream, and the European affiliates of the two US clearing banks, JPMorgan Chase (JPMC, London) and Bank of New York Mellon (BoNYM, Brussels). As the main repositories of fixed-income securities, the two ICSDs facilitate most of the triparty repos executed against relatively liquid fixed-income collateral and also, increasingly, equities.
Fragmentation is not an issue in the United States, because both the US clearing banks have a Fedwire and a Depository Trust and Clearing Corporation account, in which reside the securities they settle for the triparty repo market. With T2S, the Europeans will have only one settlement system that will lead to more efficiencies.
In Europe, Euroclear and Clearstream are the largest providers of triparty agent services to market participants; however these ICSDs are not well integrated with each other or with the national CSD in each country in an operational sense. Securities must be moved from the CSDs into an account at an ICSD in order to be financed through triparty repo at the ICSD, but the fragmented nature of the securities settlement landscape in Europe has historically made such movements relatively costly and time-consuming. Over the past few years, however, some national CSDs have been reorganised and integrated with settlement platforms of either Euroclear or Clearstream, improving their links to the ICSD, with which they are affiliated, thus reducing the costs associated with movements of securities between the two. For example, Clearstream Bank, Luxembourg, consolidates a wide range of securities via multiple links with all European CSDs and then links the consolidated pool to Clearstream Banking SA, Luxembourg, and Clearstream Banking AG, Frankfurt. A significant fraction of transactions occur between borrowers and lenders at the same triparty agent bank, with little activity settling across these two service providers. An initiative by the European Repo Council, the Triparty Settlement Interoperability should improve the interoperability between both ICSDs, and is supported by the European Central Bank (ECB).
The regulators recognise the inefficiencies within the market infrastructure in terms of connectivity, standardisation and fragmentation. Some key initiatives addressing these issues include triparty reform in the US, which substantially reduces extensions of intraday credit by the clearing banks. In Europe, the two initiatives are TARGET2-Securities (T2S), a securities settlement engine that standardises cross-border settlement for the pan-European market, and the EU’s CSD regulation, which harmonises the settlement periods, trade recording, conduct of business and prudential requirements across all CSDs. A closer look at T2S launched in June 2015, provides the scale of the issue in terms of market fragmentation. It is one of the largest infrastructure projects launched by the Eurosystem so far. T2S will improve the post-trading infrastructure in Europe by providing a single platform for securities settlement in central-bank money and will substantially contribute to financial integration in Europe. T2S will consolidate across all countries in Europe the most fundamental part of the securities infrastructure value chain, namely settlement. It will be a settlement engine offering to the whole EU. The main characteristic of T2S is that it will make cross-border settlement identical to domestic settlement, in terms of cost, technical processing and greater netting in central-bank money (eg, Eurobonds become T2S-eligible).
T2S addresses the operational aspect and is thus a process for accessing collateral assets and helping to direct these assets where they are needed. However, from a transactional point of view, the client’s collateral with custodians may not be in the lending pools. Furthermore, if the collateral makes it to the lending pools, the cost of borrowing that collateral may be higher than the borrower is willing to pay (given low interest rates on cash and negative repo rates, cash may be relatively cheap compared with borrowing collateral).
Collateral with Custodians and what is on Loan
The custodians definitely have large supplies of unused collateral but the reuse of such collateral is limited due to (a) lack of efficient tools to have a clear view of their global collateral; (b) incomplete or fragmented infrastructure that is not able to mobilise the global pools and optimally deliver the collateral where required; and (c) clients who do not have need to pledge collateral.
Clients participating in securities agent lending programmes typically lend only to large broker-dealers and are prepared to accept in return only high-quality collateral for the securities they have lent. In order to further unlock the supply in agent programmes, the clients would need to be prepared to transact with new types of counterparties by approving non-traditional borrowers and accepting different levels of market risk and lower-quality collateral. Ultimately, the fee has to be sufficient to make the risk-adjusted return acceptable for the client and still make the hedging transaction economical.
Silos are also created to some extent by regulation and contract. While custodians as agent lenders have restrictions from a capital perspective, a fund, such as a UCITS fund, may be prohibited to enter into some transactions, and also not allowed to reuse the assets they borrowed as collateral.
A single set of rules and standards will be applied to all transactions in Europe, dramatically reducing the complexity of the current market infrastructure. This ECB initiative aims to have all CSDs and ICSDs within the single euro currency to exchange settlement of cash and collateral within a real-time framework, fully consistent with the existing TARGET (cash) system. Same-day settlement exists across all European markets but is fragmented across different CSDs; T2S will remove the cross-border constraints. Together, Euroclear and Clearstream hold €40 trillion in assets for clients. For example, Euroclear Group has €27.5 trillion in custody. Of this, approximately €12 trillion is in the Euroclear Bank (with about €7 trillion in Eurobonds); and approximately €6 trillion in Euroclear Ireland (EUI). Although Eurobonds will be eligible in T2S, the liquidity will remain in the ICSDs, where the dealers utilise their depot for their global financing needs. Also, the EUI has not signed on to T2S, so the €6 trillion is out of the scope of the T2S project.
One of the key reasons why there is a move to becoming a CSD or a designated securities settlement system (SSS) is that CCPs’ prudential regulation gives a preference to the deposit of collateral in accounts at an SSS, unless they have no other recourse. Global custodians do not qualify, hence the desire to get an SSS stamp. Since much over-the-counter business is moving into clearing, collateral will be flowing in the SSS direction. This may lead to some subtle differences in the micro and macro objectives. From a business angle, custodians would lose custody fees if collateral left for an SSS; hence their move to ICSDs to keep the collateral within their business franchise. On the other hand, the ECB has a vested interest, as the lack of collateral is jeopardising the T2S benefits as it impacts on the implementation of monetary policy.
The relevant articles in both the Alternative Investment Fund Managers Directive (AIFMD) and the proposed Undertakings for Collective Investment in Transferable Securities (UCITS) V stipulate that safekeeping in SSS designated under the Settlement Finality Directive is not considered a delegation of the custody function by the fund depositary. The fund depositary or his sub-custodian does not have a choice but to deposit securities in a CSD. In addition, an event occurring at a CSD still remains the liability of the depositary. All EU CSDs (including the ICSDs – Euroclear Bank and Clearstream Banking, Luxembourg) are designated SSSs.
Figure 8.2The Current Landscape of EU Settlement and the Future Landscape with T2S
When it comes to collateral, clients sign up to a credit support annex (CSA), a standardised collateral transaction document that is linked to UK or US law.
Intra-Day Liquidity: T2S and US Triparty
T2S handles only euro settlements at present. Euroclear Bank and Clearstream operate in more than 45 CSDs and allow for settlement in more than 50 eligible settlement currencies. Due to time-zone differences, it would be impossible for settlements to happen in a timely manner without intraday credit injected into the system. The key is how the credit is provided. In Euroclear Bank, all credit extensions are secured with collateral provided by the participant and thus do not provide unsecured credit extensions.
The major problem that has plagued the US triparty market is the fact that the collateral is unwound daily. That means it is returned first thing in the morning, but the cash normally moves only late in the day in the Fedwire. That creates the intraday overdraft issues. In the European triparty market, or at least in the Euroclear triparty system, the collateral remains pledged throughout the term of the deal, so there is no daily unwind. The European triparty agents handle the daily mark-to-market and substitution process. Furthermore, now with access to the ECB through triparty, the plumbing of the wide range of eligible collateral to the Eurosystem has significantly improved. This is particularly useful, as most of the 7,000 banks have no adequate collateral management systems.
There is pressure from the central banks of the Eurosystem to ensure the large ICSDs do not offer unsecured intraday liquidity. This again will push the users to either outsource via commercial money, or self-fund by connecting to central banks of the Eurosystem. T2S and triparty reform are steps in the right direction, but is the implementation and take-up by all market participants being canvassed and tracked sufficiently in order to ensure that both streams deliver effective change?
Differences between US and European Triparty Markets
The primary difference between the triparty markets in the US and Europe is that, for the most part, the EU repo market appears to be an extension of the interbank market. In contrast, the US triparty repo market is primarily a funding market for broker-dealers. European triparty repo is normally used to manage nongovernment bonds and equity (although the proportion of government bonds has more than doubled since the crisis), whereas US triparty repo is focused on Treasury and agency debt.
Panel 8.1:Custodians in the Global Financial System
At the time of writing, two global custodians, JPM and the BoNY, and the two established ICSDs, Euroclear and Clearstream, hold the bulk of assets under custody. The pressure is now on these four providers to ensure they have connectivity with every major market infrastructure so that the global financial system can optimise their assets in the most efficient and timely way possible. For the purpose of trading, these assets are already being lent to many broker-dealers. However, new regulation is likely to increase demand for collateral upgrade trading (ie, giving a lower-quality security such as an equity or corporate bond as collateral against a US Treasury borrowing).
Where a securities lending agent has agreed to indemnify the difference between the value of collateral and the cost of replacement securities in respect of the client’s loans to the borrower, increasingly the agent will face a capital cost for agreeing to make such indemnification, which raises the cost of borrowing the collateral. In the US, the capital charge under the standardised approach for indemnifying a collateral upgrade trade using equity collateral (assuming a 10% margin) is between 9–10% of notional.
If the agent were to step in as principal or lend as agent to the dealer the balance-sheet costs for the agent would be substantial, especially the requirement for return on leverage capital, requiring a fee that would probably make the hedge uneconomical. Also, since most derivatives have a long tenor (5–30 years), there is the issue of tenor mismatch; many clients are required to terminate lending transactions immediately and cannot enter into long-term trades.
While the US remains in isolation, the new emerging-markets infrastructures, such as Russia and Taiwan, are now connecting to the ICSDs, opening up new forms of liquidity. Asia and the emerging markets are still behind in this area, due to local market regulations, but in time these markets will hopefully loosen regulations to allow securities to move across borders and be held by the ICSDs, allowing further sources of collateral. Other regions are even less homogeneous than Europe, with individual countries looking to connect with the global infrastructure via ICSDs. While the mobilisation of eligible collateral may improve in Europe, Asia is likely to see stranded collateral silos, unless local laws embrace cross-border rehypothecation of securities. Asian and Middle Eastern clients would need to agree to take that lower-grade collateral, since US Treasuries (USTs) versus cash is not a collateral upgrade. Market sources indicate that Asian clients are now lending USTs versus lower-grade government bonds and asset-backed securities (ABSs) directly. These trades are increasing in size and number, thus some clients are addressing the risk–reward issue.
It is important to understand the relative complexity of the European repo market environment, particularly with respect to settlement. Trading in Europe occurs in several different time zones and currencies, with different time cut-offs for settlement across different national settlement systems. Trades can also occur on a cross-currency basis. Furthermore, as noted above, the clearing and settlement landscape in Europe is relatively fragmented. Each country has its own central securities depository, and linkages are not yet well established between these national settlement systems, or between them and the ICSDs. In this sense, the European tri-party market is a single market for cash, but not for collateral, since cash can be lent anywhere, but an Italian or a German bond, say, can generally be financed only in an ICSD or via its national CSD. T2S is an ongoing initiative to improve the integration of European settlement systems and streamline the ability of European borrowers to mobilise collateral across national boundaries. The collateral that is eligible within the European market is not limited to European securities but also includes American and Asian collateral.
In European triparty systems, there has always been true term repo.
Service providers have developed sophisticated technology to facilitate the automated withdrawal of securities and simultaneous substitution of other securities into a cash lender’s clearing account, so that the collateral provider can withdraw securities at essentially any time, as needed to satisfy delivery obligations, while keeping the cash lender fully collateralised at all times before a repo matures.
Cash investors in the European triparty repo market include central banks, supranational institutions and deposit-rich commercial banks. In some cases, nonfinancial corporations also provide cash. Pension funds and insurers are reported to be entering this market to invest cash for relatively long terms. Money market mutual funds (MMMFs) play a smaller role in the European financial system than they do in the US, and, likewise, represent a smaller share of triparty repo cash investors. Also, before the failure of Lehman, securities lending in Europe was predominantly carried out against securities collateral. Hence, securities lending agents did not have pools of cash collateral comparable in size to those of their US counterparts, which were directed into instruments such as tri-party repos. Since the financial crisis, securities lending is increasingly executed against cash collateral in Europe. While many cash investors have an account with only one clearing bank, the largest cash investors typically have accounts with both clearing banks, Euroclear and Clearstream, and can therefore lend to any collateral provider.
In the US, many of these dealers depend on the triparty repo market as a way to fund their portfolios of securities and those of their clients. Dealers use this market to obtain short-term financing at a low cost and in a manner that preserves more or less continuous access to their securities to facilitate deliveries and receipt of securities. Cash providers in this market are primarily MMMFs, securities lenders, mutual funds, insurance companies, corporate treasurers and state and local government treasurers. These investors seek interest income at short maturities. For some investors, overnight repos serve as a secured alternative to bank deposits. Together, MMMFs and securities lenders account for over half of all triparty repo lending.
These distinctions between European and US practice may reflect in part the prevalence of the universal banking model of the European financial-services industry, whereby a larger share of securities is held in the banking system than is the case in the US, where leveraged broker-dealers hold a major share of US securities issuance. Further, the two ICSDs handling triparty repo clearing, Euroclear and Clearstream, have membership criteria that allow participation by a somewhat limited set of non-bank participants. A lender without direct access to an ICSD will typically conduct its triparty repo transactions through a bank that acts as its agent.
Panel 8.1:Securities Lending and Why this Market is Unlikely to Bounce Back
Although the large banks are unlikely to make room for the high-volume, low-margin securities-lending business (due to leverage ratio), it is often assumed that the major custodians like BNY Mellon, Citi, State Street, Euroclear, and Clearstream will have balance sheet space to move collateral around. Assets held by custodians are not part of their balance sheet, only principal positions are on the balance sheet. However, indemnification requirements to the client entails upfront capital provision and this is not cost-effective. Pre-Lehman, dealers would oblige the custodians who pushed out general collateral (eg, IBM or Merck equities) along with “specials” that the dealers really wanted (and still do). In this era, the custodian would set general collateral (GC) to a specials ratio as high as 5:1 or even 13:1. There was less balance-sheet constraint back then, and there has been no tying of GC to specials since the mid-2000s.
The asset-management complex continuously reinvests (via securities-lending) to maximize returns over their maturity tenor. In a repo there is an outright sale of the securities accompanied by a specific price and date at which the securities will be bought back. On the other hand, securities-lending transactions generally have no set end date and no set price although the market for defined term trades is growing securities. Borrowing is generally done with a specified purpose and in many cases a legal purpose test is required. As such, securities lending markets are utilised to borrow specific securities whereas repo markets are generally non-security specific. In 2007, securities-lending volumes were US$1.7 trillion. Despite collateral constraints, the volumes have been flat at around $1 trillion according to RMA (Table 2.2 in chapter 2). Some suggestions for uplifting the securities lending market in the new regulatory environments include the following:
❑ Non-cash collateral market in the US should work towards those in Europe; at present the US has more attractive collateral rates (than elsewhere), in part due to the repo rates floored at 25 bps at present, and part due to the Fed’s monetary policy.
❑ Equities can be increasingly mobilised and swapped with US Treasuries, but regulations may need to change here (eg, the SEC’s rule 15c3 in the US).
❑ Large holders of good collateral (eg, US Treasuries) in the Gulf region or some Asian countries cannot lend as their rules prohibit netting of sovereign client’s transactions (ie, their sovereign immunity angle). In the US almost all the states allow netting so it is easier for large pension/insurers to sec-lend to the large domestic banks. Note that non-cash trades are off-balance sheet unless the collateral is rehypothecated; so the re-hypothecation is what leads to a leverage issue.
❑ While the suppliers (ie, central banks and SWFs) may be eager to increase lending, and the demand side (ie, hedge funds) may be eager to increase borrowing, they will both remain constrained by the regulations. Banks face the leverage and liquidity ratios; custodial agents face single counterparty credit limits and conservative risk-based capital rules.
If the market were to grow back to pre-crisis size, it would probably involve a much larger participation by non-regulated institutions, and/or connect supply to demand without an intermediary. While this is possible (the FSB already has a working group to look at non-bank-to-non-bank collateral moves) it will be a very different market than the one that operates today, and one in which credit and duration management and intermediation would have to be assumed by a different group of players and potentially under a different set of rules. In summary, long-short equity via PB looks best placed so far – collateral flow is on “net” positons, and elasticity of 140% (see Chapter 2, Figure 2.1); then derivatives as collateral flows on “net” basis only (see Chapter 6, Table 6.1); then repo as it is primarily for funding and not to augment returns (see Chapter 2); then securities-lending due to reasons mentioned above.
In sum, the triparty repo market is a particularly large and important segment of the US repo market. The triparty repo market in the EU is much smaller and plays a less significant role for funding than in the US. Moreover, it is less concentrated and interconnected relative to the US. It is important to note that the EU triparty data may be incomplete due to the lack of official reporting of repo transactions.
Finally, there is momentum in regulatory circles for minimum haircuts, ie, methodology standards and numerical floors which is intended to limit procyclicality of leverage. However, regulators should not (and will not be able to) tamper with the cross border repo and securities lending agreement where haircuts are set bilaterally (see Chapter 3).