Regulations and Collateral Explained
Which and where regulations impact your Collateral Strategy.
Regulations have increased the need for transactions in demand for higher quality collateral.
As a consequence, collateral management positioned itself as a business-critical function for a wider range of institutions active in the global securities and derivatives markets, encompassing banks, brokers, investment managers, hedge funds, pension funds, insurance firms and other asset owners. Multinational corporations will also be drawn into the collateral world, both due to their use of OTC derivatives and as providers of cash via the repo markets.
Regulations have put pressure on financial institutions in using collateral and pushed these companies in reviewing their collateral strategy and infrastructure.
Below is a heat map on impact of regulations:
EMIR & DFA: Aim to reduce counterparty risk and increase transparency in the OTC derivatives market, this requires both buy and sell-side users of derivatives to post IM and VM at CCPs, typically in the form of High Quality Liquid Assets (HQLA).
Collateral impact:
Requirements by CCP for HQLA collateral on time
Requirements for Financial Institutions to deliver the Cheapest to Deliver for funding optimization
Increase focus on Collateral segregation (accounts)
Increased complexity of legal and operational processes for delivering margins, managing default risks and increased costs associated with the various solutions and infrastructure
A focus on collateral eligibility and its availability for use to meet minimum eligibility criteria.
The emergence of third parties’ services to reduce complexity of delivering collateral (tri-party)
LCR/NSFR: Part of Basel III, the liquidity coverage ratio (LCR) and net stable funding ratio (NSFR) have been developed to monitor, strengthen and promote global consistency in liquidity risk supervision.
The LCR is intended to promote short-term resilience of a bank’s liquidity risk profile by helping to ensure that the bank has sufficient minimum stock of unencumbered high-quality liquid assets (HQLA) to survive a significant stress scenario lasting for one month.
The NSFR requires banks to maintain a stable funding profile in relation to the composition of their assets and off-balance sheet activities. NSFR promotes longer-term funding stability.
Collateral impact:
As banks are required to hold increasing amounts of HQLAs, this is likely to reduce the available securities in use for collateralized funding and margining purposes. This is likely to increase the need for more expensive unsecured funding, or remain secured but with a more diverse range of acceptable collateral
Emergence of term finance through evergreen funding solutions (repo and sec lending)
BCBS-IOSCO: For OTC derivatives instruments that are not centrally cleared, the framework requires further steps to the taken between parties:
Calculation & daily exchange of Variation Margins between bilateral counterparts
Exchange of two-way IM (requiring amendments within the ISDA CSA)
Establishment of policies, procedures and controls for minimizing disputes by reconciling portfolios, risk sensitivities, risk factors and margin calls with counterparties.
Collateral impact:
Firms will need to calculate IM according to their chosen margin model(s) and will need to apply complex risk data
Firms will need to establish policies, procedures and controls for minimizing disputes by reconciling portfolios, risk sensitivities, risk factors and margin calls with their counterparts
Firms will need to meet new minimum regulatory standards on key terms in Credit Support Annexes (CSAs) so will need to re-contract with all their counterparts
The buy-side are not impacted on day one by BCBS but that some of their largest counterparties will be, however they are required to follow these rules in the future
Increate pressure on cost and infrastructure
Solvency II Directive: This EU Directive, often called ‘Basel for insurance companies’, it intends to harmonize insurance regulation by addressing the amount of capital EU insurance companies should hold to reduce the risk of insolvency.
Collateral impact:
With increasingly complex collateral requirements, it is likely that insurance companies will need to develop more sophisticated collateral solutions (i.e. collateral management/repo desks)
The lack of technology infrastructure will push insurance companies to look for service solutions
Shadow Banking Rules: As part of its efforts to strengthen oversight and minimize risk in the shadow banking sector, the FSB has called for mandatory haircuts to be applied to non-centrally cleared securities financing transactions (e.g., repo and stock loan transactions), in which financing against collateral other than government securities is provided to non-banks.
Collateral impact:
For lower quality and longer dated securities involved in Security Financing Transactions (e.g. repo), it is likely that there will be less funding sourced
The change in funding arrangements may impact the appetite to hold such securities, hence the need to optimize inventory
Changes in the funding practices (and funding cost) of SFTs may result in a greater cost of funding - with a consequential direct impact on a firm’s profitability
MiFID II: The second Markets in Financial Instruments Directive (MiFID II) creates a new category of trading venue - the organized trading facility (OTF) - on which derivatives can be traded. It also requires that all trading of derivatives that are eligible for clearing and that are sufficiently liquid take place on regulated trading venues (regulated markets, multilateral trading facilities (MTFs) or organized trading facilities (OTFs).
Collateral impact:
Increased focus on collateral requirements by smaller institutions requiring collateral services
We are likely to see increased client reporting requirements leading to an increase in operational costs
Ring-Fencing Treasury: The Independent Commission on Banking (ICB) produced the Vickers Report, requiring British banks to ring-fence vital domestic retail services from the investment banking arms to safeguard against riskier banking activities.
Collateral impact:
It is inevitable that larger UK players will be required to uncouple investment banking from retail banking activities. This increases the requirement for transparency which in turn will result in an increasing cost of implementing separate collateral solutions
Need to have a true firm-wide collateral strategy that is ‘fit for purpose’
Impact on cost and infrastructure
UCITS V: Undertakings for collective investment in transferable securities (UCITS) are regulated investment funds that can be sold to the general public throughout the EU, so it is important for them to have common standards of investor protection. UCITS V aims to increase the level of protection already offered to investors in UCITS and to improve investor confidence in UCITS.
Collateral Impact:
Non-cash collateral received:
Should be highly liquid and traded on a regulated market with the ability to value the security daily and sell it quickly, at a price that is close to pre-sale valuation
It should also be of a high quality and subject to a pre-check and on-going verification of issuer credit rating with on-going liquidity checks on all collateral received
It cannot be further used (re-used) as part of another repo, or securities lending agreement
For cash collateral received:
If UCITS reinvest cash collateral in reverse repo transactions, these should comply with rules requiring the receipt of HQLA; cash collateral received by UCITS cannot be used by UCITS for clearing obligations under EMIR
Trends
We continue to see:
Low interest rates environments increased the usage of non-cash collateral
Increased use of HQLA such as Government bonds
Increased use of Equities
Longer maturity of collateral-related transactions
Greater levels of collateral are being required for use at CCPs
New collateral requirements imposed on non-cleared OTC
Emerging markets financial institutions will need to start managing inventory of HQLA and margin requirements when dealing in non-emerging market currencies
Using collateral optimization to balance between the three key drivers: minimizing balance sheet usage, minimizing funding costs and minimizing use of collateral
Cross products margining will increase demands of having more sophisticated collateral solutions
New set of regulations in 2018
This Increased the complexity and cost of collateral management operations
Even though banks have been working on this area for few years now, we are still away from an optimal centralized collateral and inventory management linked to good risk analytics. I believe the next phase in collateral will be about the collateral Risk/Front-Office sides where banks will start implementing stress scenarios and see the impact of margin/collateral on Liquidity and processing.
BuySide firms are just starting to understand the importance of this subject and equipping themselves with a solution. Hedge funds, asset managers and insurance companies will be next in line to look for a good collateral solution, followed later on by corporates.
Firms who fail to implement a sound collateral strategy will find themselves at a considerable disadvantage. Banks may find themselves unable to fund core business lines or meet the needs of clients cost effectively; asset owners and managers may find themselves unable to pursue preferred investment strategies.
Read also <<< Are you well equipped for a Collateral Solution >>> published on January 16th, 2018
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