Despite considerable development of collateral management applications, utilities and services – and the potential benefits for asset managers from managing liquidity risk and meeting margin call obligations – there has so far been limited appetite from the buy-side.
The lukewarm interest has been exacerbated by the delay to EMIR’s requirements on OTC derivatives clearing and the exchange of initial margin for bilateral OTC derivatives, as well as a lack of clarity on the final regulations.
In the absence of a regulatory driver, revenue considerations become critical. However, some products represent functional overkill for asset managers, appearing sell-side focused.
There are also operational risk concerns for those participating in agency securities lending programmes. This is especially the case with third-party lending and exclusive deals on portfolios, which all add complexity to the location of assets, including whether they can be recalled on time for sell orders and assessing when assets are being used for collateral purposes or in lending programmes.
Further muddying the water are CCPs’ activities, exploring the provision of cross-margining and tri-party capabilities might further delay the choice between products. However, there are some very clear benefits for a buy-side firm to develop a collateral management capability in the short-term.
In the period leading up to the global financial crisis, there was an abundance of cheap client clearing services. Banks were almost exclusively the clearing members that provided these for high-volume plain vanilla OTC derivatives such as interest rate swaps.
This continued in the post-crisis period as regulation mandated the central clearing of OTC derivatives for most counterparties, which led to increased demand. However, banks have been burdened with being members of multiple CCPs to service their global buy-side clients. This, combined with changes to capital requirements, suddenly made offering client clearing services a less attractive revenue proposition, requiring strict compliance and monitoring.
This has undoubtedly pushed up costs, meaning buy-side clients transacting significant volumes across multiple CCPs could certainly benefit from the ability to self-clear.
Minimising yield drag
Investment and wholesale banks have traditionally been providers of liquidity to the buy-side. However, capital adequacy requirements and balance sheet usage mean that collateralised transactions versus cash have an adverse balance sheet impact, even with the highest quality collateral. Where transactions are collateralised with non-sovereign assets there is an impact on risk-weighted assets (RWAs) and capital adequacy ratios, all of which is reflected in the rates they can provide.
There is value in seeking non-traditional counterparties that don’t face the same constraints, such as other buy-side entities including corporate treasury desks. In this context, tri-party looks very attractive as it enables the collateral giver to commoditise pools of assets and outsource the re-valuation, recalls and substitutions to the tri-party agent. Services such as Euroclear’s RepoAccess take the headache out of negotiating individual GMRAs with each counterparty. Other products are in development so a different landscape is emerging.
Managing liquidity is a significant task for portfolio managers and being prepared for investor redemptions, managing portfolio restructuring, meeting margin call obligations, covering liquidity shortfalls and investing excess liquidity has required investment in dedicated teams and technology. Yet, with major currencies offering near zero or negative interest rates, the disparity between the yield of a strategically-invested portion of a fund and the portion that is invested in short-dated products is considerable.
The impact of the poor return from the liquid portion of a fund’s NAV on the overall return, the so-called yield drag, could be partially mitigated by rebalancing the ratio of the strategically-invested portion to the short-dated liquid portion.
The transformation of strategic investment assets into high quality liquid assets (HQLA) would enable a similar liquidity ratio but offer the ability to readily raise cash against the HQLA, or use HQLAs to meet collateral obligations. The annual cost of collateral transformation is a fraction of the yield improvement gained from reducing a fund’s liquidity.
Collateral optimisation has traditionally been a sell-side concern, as it is typically leveraged and focused on balance sheet usage. The focus for the buy-side is different, with a decision process that determines the deployment of expertise and resources for core activities while outsourcing non-core activities. It is imperative that collateral management is given attention so it can have an impact on the bottom line, rather than just ticking a regulatory box.
Jonathan Adams is a principal consultant and practice lead of Delta Capita