2008 to 2018 – a view on the global collateral markets
Has change been driven entirely by regulatory compliance or have market forces also played a role?
A constant theme at repo and collateral management conferences over the past 10 years has been how these markets are coping with the litany of regulations imposed on them following the demise of Lehman Brothers in September of 2008.
US tri party repo reform, the LCR, NSFR, leverage ratios and US IHC have all been imposed upon the secured financing market. The migration of the majority of derivatives trading to central counterparties and the requirement that non-cleared derivatives be margined have also had a major effect on the area of collateral management.
Recent conference panel discussions of these subjects all too often fell into a common pattern lamenting the onerous constraints imposed upon market participants. Rarely did panellists focus on how they, themselves, have adapted their behaviour to ensure that the crisis of 2008 will not happen again.Some market reforms were probably only possible with regulatory guidance. US tri party reform falls into this category.
While everyone could recognize the risk of virtually unlimited daylight liquidity in the US market, remedying this situation in a timely manner was probably only possible with the Fed directing the market’s efforts across the then two clearing banks.
The migration of a majority of the OTC derivatives market to central clearing probably also falls into this category.
Was regulatory change the catalyst?
At the same time, one could argue that many market changes likely would have occurred organically. And, although solutions might have differed from the reforms imposed by regulators, the effect would have been the same: a safer, sounder market.
The catalysts that led to the demise of Bear Sterns and Lehman Brothers, as well as the near-death experiences of several other market participants, were in large part the market’s almost complete reliance on overnight funding and many participants’ excess leverage, particularly in the financing of non-liquid assets.
In the immediate aftermath of Lehman’s bankruptcy filing we saw several market players initiate the process of converting to banks, therefore gaining emergency access to the Fed’s discount window.
Across the board, we saw dealers cut back on the leverage they were willing to provide to clients; haircuts were increased dramatically and assets scrutinized.
And, the third piece of this solution – extending the tenor of funding transactions – was well under way before the LCR was introduced to the market.
Adapting and reducing leverage
All of these steps demonstrate that the market as a whole identified the same risks that the regulators identified and began implementing its own solutions immediately after September 2008.
Whether imposed by regulators or implemented organically, one recurring theme in the market’s reform is the reduction of leverage. Prior to the crisis of 2008, SIFMA reported the repo balance sheets of US primary dealers peaking near $7 trillion.
As of the end of the third quarter of 2018, this number stood at $3.7 trillion. This is an astonishing change which cannot be attributed entirely to regulatory compliance, as the vast majority of this reduction occurred prior to the imposition of regulatory reforms.
Additionally, regardless of regulatory burdens and market dynamics, participants will constantly pursue enhanced profitability through operational efficiency.
The steps we have seen in the secured financing and collateral management markets to identify and deliver the ‘cheapest’ possible asset to each exposure illustrate this dynamic and are the driving force behind the integration of these two formerly siloed functions.
So what are the themes we are seeing across the market now that we are 10 years down the road?
The formerly siloed functions of securities finance and collateral management are becoming increasingly integrated as participants pursue cost savings as well as regulatory compliance. This integrated collateral optimization model is being implemented on a global basis. This process in turn requires significant innovations in the management and mobilization of collateral, including ready available settlement and allocation updates with standardized reporting.
The importance of repo desks
The crisis has served to raise awareness of the importance of sufficient liquidity, extended funding horizons, central clearing, conservative leverage and adequate margins. It has also served to reinforce the importance of firms' repo desks. At both dealers and hedge funds these desks require individuals with broad market perspective and an ability to manage multiple simultaneous regulatory, market and counterparty challenges.
It is clear that the financial markets in general are on firmer footing. Longer-term funding, reduced leverage particularly for non-liquid assets, dramatically reduced daylight exposure, CCPs and the collateralization of a broad range of unsecured exposures have dramatically reduced the systemic risk of not only funding and collateral management but the broader capital markets.
Complying with regulation
This new environment has resulted in a new set of challenges for firm and client funding/collateral management. Compliance to multiple overlapping regulations creates a constantly shifting landscape for repo traders and collateral managers. In particular, the required reduction in leverage presents unique challenges to dealers providing funding and securities lending services to their clients while LCR and NSFR regulations restrict the terms under which these transactions can be structured. The expanding scope of OTCD collateralization is requiring more and more market participants to focus on effective collateral management and margin posting.
Financial market infrastructure is taking centre stage
Upgrading market infrastructure is proving to be of tremendous importance. Central clearing, the global mobilization of collateral and the need to improve accuracy while adhering to multiple constraints requires more and more sophisticated back and middle office systems.
Opportunities abound for innovative solutions
We are seeing new tools – DTCC Sponsored Clearing which allows dealers to continue to arrange funding for their clients while not tying up precious balance sheet, DTCC-Euroclear GlobalCollateral’s Inventory Management Service and the Collateral Management Service CMS which allow banks to manage collateral intra-day and on a global scale – and new counterparties (additional banks/dealers), as well as all-to-all platforms reshaping the market. In addition, the Fed has recast the landscape with its decision to pay interest on overnight excess reserves and its own repo offerings.
Dealers are still kings
Although some volumes have shifted to all-to-all platforms and the net of CCPs has been widened, dealers still remain central to the global funding market. Banks are less levered in the current environment but they still control substantial balance sheets and provide the sponsorship for buy-side institutions to access CCPs. In addition, their ability to mitigate the mismatch in funding requirements of various market participants ensures that they will continue to perform a vital role in the global funding markets.
Collateral optimization 2.0|
We are seeing a new need for collateral optimization to reflect the attributes of the individual exposures in addition to the attributes of the underlying collateral.
All of these innovations reinforce the adaptability of markets and their participants’ constant pursuit of solutions to solve structural shortcomings. It is often overlooked how many of these solutions are organic in nature.
Oscar Huettner joined DTCC-Euroclear Global Collateral Ltd in New York in 2014 as a member of the product development team building the Collateral Management Utility.