Collateral Liquidity Seen Drying Up

Terry Flanagan

The forthcoming derivatives regulations in the U.S. and European Union represent a huge operational challenge for asset managers and other investors; and a potential drain on collateral liquidity.

“Collateral liquidity is causing huge concern at the moment and this could really move towards the top of the industry to-do list by this time next year,” said Gary Wright, chief executive of B.I.S.S. Research, a London-based research firm.

A critical requirement is the ability to automatically reconcile the collateral system with the collateral positions at custodian banks.

Asset managers need a flexible collateral process that works across all their custodians and enables them to move assets directly between custody accounts and counterparties, without the use of staging accounts.

“OTC is very likely to suck even more liquidity from the market, and with regulatory and political interference with short selling and stock borrowing and lending, the liquidity problem in collateral could escalate very quickly,” Wright said.

The transition into the post-Dodd-Frank, post-Emir regulatory environment holds huge implications for asset managers, none more so than collateral management.

Firms that participate directly in the $700 trillion swaps market will be forced to undertake collateral optimization programs in order to unlock an expected $1.6 trillion to $2.0 trillion in collateral shortfalls, according to research firm Tabb Group.

“In the OTC derivatives market, we see collateral messaging and management as one area where data workflows need to change or risk being overwhelmed,” said Michele Carlo, managing director at MarkitSERV, a provider of electronic trade processing for OTC derivatives.

Analysts foresee sustained investments in risk management software to allow a granular understanding of total holdings and embedded risks, speed up ad-hoc scenario analysis and stress tests, and update existing regulatory capital calculators satisfying deadlines set by national regulators.

One area of focus is collateral messaging.

“We expect the volume of messages about collateral requirements for bilateral trades to increase significantly as a result of Dodd-Frank,” said Carlo. “With our partner, AcadiaSoft, our portfolio reconciliation tools enable the buy side to effectively manage margin calls, reconcile their positions and even pull in independent valuations from Markit. Multi-functional solutions like this are critical for buy-side firms to be efficient, both operationally and technologically.”

One potential solution to the liquidity shortfall is to initiate increased trading activity between the retail and wholesale markets by creating a central market that focuses on particular investor needs.

“If stock exchanges could release the huge mountain of private investor assets into the markets it might plug a bit of the collateral hole which is emerging,” said Wright at B.I.S.S. Research. “The question is, apart from NYSE Euronext, who else could join in and create a stock market geared to investor needs?”

Citi has enhanced OpenCollateral, its collateral management platform, to provide asset managers with automated collateral position reconciliation via Swift.

This new capability streamlines collateral management by creating standardization across funds and custodians, requiring fewer collateral accounts and reducing the number of collateral instructions.

The facility also supports the tracking of direct movement of collateral between client custody accounts and counterparties, without the need for channeling collateral flows through staging accounts.

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