Buy Side Concerned About Collateral Costs 

Shanny Basar

A third of buy-side firms are concerned that new regulations will increase the cost of collateral and clearing services and that some brokers may be less willing to offer these products.

GlobalCollateral, the joint venture between Euroclear and the US Depository Trust & Clearing Corporation, commissioned consultancy Aite Group to conduct a study “Derivatives Collateral Management: Entering the Industrial Age?” Aite interviewed 34 firms across the globe  this year to examine recent developments in derivatives collateral management activities.

Basel III requires sell-side firms to hold more high-quality liquid assets on their balance sheet which means they may have fewer assets available to pledge as collateral and increase the cost of pledging these assets. One brokerage firm told Aite that the liquidity coverage ratio is particularly challenging because they have to consider potential increases in market volatility that may impact the quality of collateral or potential future exposure of derivative positions.

As a result the buy side is concerned about the possible increase in the cost of services provided by their brokers.

“Smaller asset managers are also concerned that brokers may be less willing to do business with them as a result of the higher costs of doing business overall,” added Aite. “A Tier-2 asset manager respondent indicates that the implementation of Basel III is governing banks’ economic approaches to capital, which has resulted in changes in their client charges for repo and clearing activities.”

The survey found that the biggest challenge for the buy side is the labor-intensive collateral management process due to the lack of internal and external automation. Many respondents would like to see centralized services to support collateral mobility and margin message communication.

“A Tier-2 asset manager indicates that the firm struggles to respond to calls in a timely manner intraday because it is reliant on staff members rekeying data received from counterparts via email, which is inefficient and risky,” said the report.

Aite added that buy-side firms would consider outsourcing either part or all of the collateral management function, depending on the growth in their use of derivatives instruments.

The primary challenge for sell-side firms is the ability to move collateral around the globe to meet collateral requirements or calls in specific countries. The US introduced mandatory clearing for some interest rate derivatives in 2013 while the European Securities and Markets Authority is still reviewing technical standards before mandated clearing is due to come into force next year.

“One of the most notable cross-border discrepancies is between the United States and Europe around the treatment of risk and margin mechanics for central counterparty clearinghouses, which has been the subject of debate throughout the first half of 2015,” added Aite.

The Bank of England’s Quarterly Bulletin for the third quarter of this year said that since the 2013 introduction of the US clearing obligation, 80% of new interest rate contracts and 70% of new credit derivative contracts have been centrally cleared.

Arshadur Rahman of the Bank’s financial market infrastructure directorate, said in the paper: “In managing risk in the financial system, central counterparties do however concentrate risk within themselves. This will become an increasingly important consideration, since there is likely to be further migration towards central clearing, and more concentration of activity among a small number of CCPs and their users.”

Rahman said the majority of initial margin requirements at the four UK CCPs at the end of last year was from clearing members located outside the UK – with 39% provided by clearing members based outside the European Economic Area. “Given that so much OTC derivatives activity is cross-border by nature, the timing and scope of implementation of the clearing obligation in different jurisdictions is particularly important,” he added.

This highlights that OTC derivatives transactions frequently involve counterparties from more than one jurisdiction and that in order to clear at the same CCP, that clearer must be permitted in both jurisdictions.

Emir allows for recognition of CCPs from other jurisdictions that meet certain conditions which are equivalent to those in the EU. However Esma has created controversy by not yet recognising US CCPs.

The Bank of England said: “It is also desirable that authorities in different jurisdictions co-operate in considering which OTC derivatives products should be subject to a clearing mandate. EU and US authorities have committed to do this.”

Photo by Mark Carrel/Dollar Photo Club

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