Anne-France Demarolle, head of liquidity management at Societe Generale Securities Services
Pierre Lebel, group treasurer and head of client collateral management, Newedge
Angela Osborne, co-head of agency cash management, Newedge
Chair: I am sure you have seen the variety of estimates for the predicted collateral shortfall ranging from $800bn to trillions. Do you think it will be as large as some of the reports predict and, if so, what strategies do you have in place?
Anne-France Demarolle: There were many reports warning of a collateral shortfall a year ago. If you look at it, to date, there has been no collateral crunch. One can point to many reasons such as the delays in implementation of regulation, especially European Market Infrastructure (Emir) and the mandatory clearing of some OTC derivatives. In addition, the financial system is awash with both cheap cash and a large supply of high-grade government bonds that can be used as collateral.
This is mainly due to the huge deficits run by some countries in Europe as well as the US and Japan. I do not think there will be a shortfall but see the focus being more on the process to realise the right collateral in the right place at the right time, to cover collateral needs.
Angela Osborne: I think the general consensus is that there will be a time lag between when Emir goes live and a potential collateral shortfall. This is due in part to the fact swaps are only eligible for clearing upon execution versus grandfathering an entire book, so one would expect to see pressure on collateral build over time. The question is, when will the collateral squeeze happen? Will it be in 12 or 24 months? Or, perhaps it may never materialise.
Looking ahead, problems could be mitigated by additional asset classes being eligible for central clearing. For example, there is talk of allowing exchange traded funds (ETFs) and money market funds being accepted as eligible collateral at central counterparties (CCPs) and exchanges. Such measures should help widen the available pool of collateral for margin purposes and hopefully unlock any potential squeezes in the collateral market should they emerge.
Philippe Karriere: There are two sides to this equation. We have seen the figures being published. But taking just the sovereign debt of the US and Japan, the amount of eligible collateral assets has increased by $11trn since 2007. However, those reports and figures sometimes help market participants put collateral, as a topic, on the map. These headlines woke up the industry. It forced all of us to start to think about collateral management and optimisation.
Looking at the bigger picture, what are the main challenges facing market participants in managing and optimising collateral today and in the future?
Pierre Lebel: It depends on who you talk to. If it is the sell side and the larger banks, they have experience managing collateral in the bi-lateral world and are well prepared with the resources and personnel to deal with the additional requirements and reporting.
This is not necessarily the case with the small to medium-sized firms. They are not ready. Regardless of size, it still means having the processes in place to manage contracts and updating them to comply with the new regulation. It also involves managing the independent valuations and margin calculations. These tasks not only include the back to middle office but also the front office functions. In the end, it opens new business opportunities for those that can provide collateral management services.
Demarolle: I see three challenges for market participants, although they will differ depending on their size. The first is that, due to the sheer number of regulations, firms have to figure out which rules apply to them and the jurisdictions where they operate. There are also different regulations for different sectors, for instance banks have to meet Basel III while the insurers have to comply with Solvency II. Each one adds to complexity, but securities services businesses can help clients navigate the regulatory landscape and understand which rules apply to them.
The second challenge is identifying your collateral requirements and collateral resources. Third – and this is one of the main issues – is the organisation and technology that firms will need to implement. All of these new processes come with a cost, and some of the functions that were seen as back office or treasury, such as collateral management, are increasingly becoming a front-office activity.
Karriere: Another issue that market participants will have to deal with is the eligibility of collateral. Some clearinghouses have been reviewing their collateral schedules and others, such as Eurex, accept commodity certificates such as Xetra-Gold as eligible collateral. In terms of liquidity it is positive, but it also demonstrates the huge layers of complexity that have been added to the whole process.
How prepared is the buy side? Is the situation similar to the one on the sell side, where the larger players are making the most progress?
Osborne: We have seen the buy side preparing for Dodd-Frank and Emir from a regulatory and operational perspective, but clearly the funding requirement has been a lesser priority. For example, most of the tier-one buy-side clients, or those that are going to start clearing under Emir next summer, are clearly prepared in terms of choosing their clearing member brokers. But I think the bigger question is around the level of financing and the credit lines that they have in place. Are they comfortable that they have adequate funding facilities in place to cover their initial or variation margin requirements in the event of a tail-risk event?
This all comes at a time when banks are reducing their balance sheets under Basel III’s liquidity coverage ratio (LCR). This generally does not impact the tier-one clients that have access to adequate funding lines, but rather small and medium-size clients.
The challenge for this segment is that they are not collateral managers by trade and would need to become repo specialists. The clock is ticking and I believe clients should start focusing on alternative solutions and other agency-like products such as our Agency Cash Management (ACM) offering in the event they hit their credit limits with their primary lenders – particularly during times of crisis. The tri-party repo mechanism is a solution for this community as it eliminates much of the operational work required to transform cash and collateral for clearing purposes. Our ACM offering accommodates tri-party repo across all four of the tri-party agents.
Demarolle: I agree that there does not seem to be the same pressure at the moment between sell side, where optimisation of collateral is very high on the agenda, and the buy side, which, although depending the institution’s size, is not behaving in the same way. The small and medium-size clients seem to be in a wait and- see mode and are reacting to what is happening on the sell side and what banks are willing to commit in terms of their balance sheet.
Many of the larger banks are developing the same products and services, so how do you differentiate your offering?
Lebel: The Societe Generale offering is differentiated in the areas of optimisation and transformation. For example, firms managing, say, half to one billion euros in assets might generate around 50 to 60 transactions per month. It would not be economically viable for them to have an optimisation engine for managing and posting the cheapest collateral. It would also be expensive to have a team in charge of transforming ineligible or assets with deep haircuts via repo to go through the CCP.
This opens the door for service providers. We have a collateral management service for Newedge clients that has been expanded to the rest of Societe Generale’s clients. We are also working on a centrally managed pool of assets. We also offer middle office services of valuation, reporting and dispute management in the OTC world. Although other banks are offering a global-investor solution, we have been doing it for a longer period of time.
Demarolle: I also think there is a premium for service providers that can encompass the full spectrum of services ranging from connectivity for clearing members for collateral transformation and the necessary administration tied to the valuation and daily margin. Custodians have moved into this space because the infrastructure needed to do collateral management or transformation is not very different from agency lending.
Karriere: It is not just about the cost, though. It is also about the expertise that a firm such as Societe Generale can bring in terms of generating outperformance on a portfolio return.
Osborne: In terms of us being separate from the rest of the pack, we have our ACM product that allows clients to transform cash and collateral in an efficient and transparent manner. We were the first to the market with this cash-and-collateral tri-party repo auction, designed for the buy side – it is what we call a bank-toclient (B2C) offering. It could potentially be client-to-client (C2C) offering – it is an innovative solution that, at this point, our competition does not have.
Many of the large sell-side firms are prepared for the new OTC regulation but some have had to restructure their operations. What has Societe Generale done?
Demarolle: You have to break down silos because whether it is cleared or uncleared OTC derivatives or securities lending, everything comes back to collateral. This means consolidating all inventories of assets to be able to post and check you have the right collateral in the right place, at the right time. It is a question of putting everything together. We have already looked at the different departments or subsidiaries of Societe Generale and have identified the building blocks.
Lebel: It was about integrating existing services, such as the client collateral management of Newedge with the middle office services of Societe Generale Securities Services into a third-party offer. It enables us to offer new services and financing to clients. With securities financing as well as prime brokerage, there comes collateral management. It is all intertwined. However, we believe it is the right time to offer those collateral services to clients that cannot manage them internally, as they are too expensive, complicated or time-consuming to do. It is important to be flexible.
What role does securities lending play in the new world of collateral management?
Demarolle: I think securities lending is the basic transaction that you can do as a transformation trade so, when it comes to transformation of collateral, it will be a key feature. It means that institutions that need collateral or eligible assets will be able to find them. At the moment, there may not be a collateral shortage but some beneficial owners are not lending their securities and especially their high quality liquid assets. The reward is not compelling for the time being – they are just waiting so their collateral is not on the market.
The other issue is that the terms under which the borrowers are ready to borrow are not always the ones that the beneficial owners want. The good thing is that the new regulations contribute to demystifying what securities lending is by providing more transparency on the use of assets, market participants and further details of the trades, while rejecting the most aggressive schemes. This is especially important when people see it fall under the label of shadow banking.
Karriere: I think transparency will be good but there is still some uncertainty over parts of the regulation such as minimum haircuts, which will need clarity and could add another layer of complexity.
Lebel: A large part of the need for collateral will actually be for variation margin. This has to be paid in cash, so the need to have an instrument that allows you to transform the security into cash to post the margin will be increasing. This means that if you only have securities, you have to change them quickly into cash via the tri-party repo mechanism. By combining this with our e-platform, ACM can help you achieve this in a fast and operationally efficient way.