Collateral Shortage Is Unlikely

Terry Flanagan

An overall shortage of collateral is unlikely despite new regulations although there may be bottlenecks according to research from the London School of Economics and Political Science.

Professor Ronald Anderson Anderson and Karin Jõeveer at the LSE published “The Economics of Collateral”, a study supported by The Depository Trust & Clearing Corporation, the US central clearer.

The paper said: “It is unlikely that there is an overall shortage of collateral. However, it is quite possible that there may be bottlenecks within the system which mean that available collateral is immobilized in one part of the system and unattainable by credit-worthy borrowers.”

The academics said that at the end of 2011 the total amount of US Treasury securities outstanding was $10.4 trillion and collateral could also include corporate debt and some mortgage debt.

However as the demand for collateral increases due to regulators forcing more over-the-counter products to become centrally cleared, the relative cost of high quality collateral is likely to rise.

The study said: “One way in which the effects of increasing relative scarcity of collateral might be mitigated would be in increasing the reuse of collateral by market participants.”

Ted Leveroni, DTCC executive director for business development and external relations, told Markets Media: “Infrastructure providers can play a critical role in solving collateral bottlenecks. At DTCC, we are actively working to create the pipes that allow collateral to flow more freely.”

The DTCC is developing a margin transit utility that will provide straight through processing for the settlement of margins.

Leveroni said: “Our margin transit initiative identifies where collateral is and automates the settlement process. Once an industry standard for settling collateral has been established, there will be plenty of additional opportunities in this area.”

In May the boards of the DTCC and Euroclear, the settlement provider, authorized their companies to finalize a joint venture to launch the margin transit utility.

“The joint venture with Euroclear will globalise cross-border settlement and expand the view of collateral,” added Leveroni.

Godfried de Vidts, chairman of the International Capital Market Association’s ICMA’s European Repo Council, said in a statement: “We are at a cross-roads as an industry, where collateral is available to satisfy counterparty and regulator needs, yet credit-worthy borrower access could become threatened due to scalability issues related to an increase in margin calls and a lack of standardized global solutions across markets and firms. Now is the time that the industry must work together to ensure streamlined access to collateral worldwide.”

Leveroni said the margin transit offering should make the transition to Emir more efficient and workable for market participants. “We are defining the details of the margin transit offering with the industry and putting finishing touches on the model before it is rolled out next year,” he added.

This month the European Securities and Markets Authority added Germany’s European Commodity Clearing and the UK’s LCH.Clearnet Ltd as authorised CCPs under the European Markets Infrastructure Regulation taking the total to eight approved CCPs. Emir will require certain standardised OTC products in the region to be moved onto exchanges and centrally cleared.

The LSE found that the advantages previously enjoyed by large banks in collateral management, such as their natural economies of scope in collateral transformation, are being eroded. This is creating an opportunity for CCPs and other non-bank competitors to increase collateral transformation services. As clearing becomes mandatory for some OTC products, CCPs will be able to develop new products that were uneconomic at a smaller scale.

Morgan Stanley and Oliver Wyman have argued that OTC derivatives reform could produce revenues of between $5bn and $9bn from collateral management which will be captured by three to five CCPs and two to three international central securities depositories.

“Ultimately this prediction may prove correct, but this stage it is hard to point to direct evidence of such a consolidation of activities,” said the LSE study. “In our view it is still hard to predict what will be the dominant business model for collateral management or even if a single model will prove dominant for long.”

However the LSE paper warned that if clearing becomes consolidated the dominant CCPs would become systemically important. “A possible advantage of this is that regulators and supervisors will know that they need to focus their attentions on the risk management practices of these important institutions,” the study said. “The disadvantage is that the framework for supervision and for resolving a systemically important CCP have not been firmly established.”

The LSE also warned that greater reliance on collateral will not eliminate credit risk. The paper said: “The search for new methods of achieving economical collateral transformation is giving opportunities to market infrastructures and others to provide much needed support for credit creation. In the process, the patterns of risk bearing will be changed, and understanding this represents a challenge both to regulators but also to investors.”

Featured image : Screengrab via The Economics of Collateral

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