An article in the Financial Times last week (5 March 2013) discussed the latest idea in the derivatives market: the business of “collateral transformation”.
As a reaction to the global financial collapse, regulators are introducing a clearing system for the majority of over-the-counter derivatives. They are requiring parties to run their derivatives trades through so-called central counterparties (CCPs). The idea is that CCPs stand between the two sides of a trade, providing a buffer by guaranteeing payment under the trade if one party defaults. The CCP is able to guarantee payment because collateral is paid to the CCP. That collateral has to be high quality – government bonds or cash – safe enough to protect the CCP if a default occurs. Even if a derivative transaction does not have to be cleared, it is likely to be subject to new collateral requirements.
These regulatory requirements have therefore increased demand for high quality collateral. Estimates of the extent of the collateral required vary, but range from $500bn to as much as $10tn.
Various financial institutions propose to satisfy that demand by using the decades-old securities lending and repurchase (known as “repo”) desks. In essence, a customer pays a fee to borrow better securities than it currently holds thereby improving the quality of its collateral. This process is being called collateral transformation.
By way of example, if a customer holds junk bonds, a financial institution would take the junk bonds and lend Treasury bills or cash to the customer for a fee. The customer is now able to provide the necessary high quality collateral to the CCP, and it can go ahead with its derivative transaction. Its collateral has apparently been “transformed”.
At least two risks appear to arise. First, in times of market stress, the price of borrowing in the repo market will increase at the same time as the demand for further collateral. Therefore, just when the customer needs the collateral most, it is likely to become unaffordable. This, in very simple terms, was Northern Rock’s problem: reliance on the affordability of a supply of finance which is inherently unaffordable in times of market stress. Second, the junk bonds do not disappear of course. In reality, there is no transformation at all. When the music stops, someone will be left holding worthless collateral. The risk has been shifted, not removed.
The regulators are demanding a higher entry fee to the derivatives market (the high value collateral requirement). Collateral transformation enables the customer to borrow the entry fee; but does that not allow into the market the very people that the entry fee was designed to exclude? The regulators want to bar from the market those who cannot bear their losses. We should ask whether collateral transformation lets them in.
The tail seems to be wagging the dog. Collateral transformation is an industry developing because customers do not have adequate collateral to enter derivative trades. In other words, because the customer cannot afford to acquire high value collateral outright. Instead of conjuring high quality collateral from the repo market, the better course might be for the counterparty to re-think its hedging strategies based more closely on what it can afford.
If something sounds too good to be true, it probably is.
Gibson & Co.
March 2013