Jun 6, 2013

Derivatives Collateral Shortage - Crying Wolf or a Reality?

Watch the Video: Derivatives Collateral Shortage - Crying Wolf or a Reality?

In this video blog Denny Yu, VP of Client Solutions and Risk Product Manager talks with Jim Jockle, CMO about a new report from the Bank for International Settlements which claims there’s no evidence of collateral shortage, raising eye brows in the face of widespread concerns over “collateral crunch” – due in large part to collateral requirements for mandatory central clearing.

Denny provides reaction to this issue, discussing collateral crunch not as a global phenomenon but as a short-term concern of countries with less high quality sovereign bonds. Denny also touches on a number of concerns such as the impact of covered bonds being more widely accepted as higher rated securities, and the role of collateral transformation in creating interdependencies between counterparties.

With initial margin and central clearing here to stay, Denny concludes with call to action – stressing the need for more advanced analytics to effectively predict or forecast collateral needs.

Weigh in and continue the conversation on Twitter @nxanalytics, LinkedIn, or in the comments section.

Video Transcript: Derivatives Collateral Shortage - Crying Wolf or a Reality?

Jim Jockle (Host): The OTC market has outted its Chicken Little and the collateral sky is no longer falling. According to a new report from the committee on the financial system a central bank form of the bank of international settlements, the collateral short fall that has been widely reported on, appears to be grossly overstated. I’m Jim Jockle your host on Numerix Video Blog. With me today, Denny Yu, Project Manager from Numerix, and part of the Risk Team, how are you Denny?    

Denny Yu (Guest): Good, good. I’m very glad to be here Jim. Thank you.

Jockle: So I want to talk about this. William Dudley who is Chairman of the Committee and President of the Federal Reserve Bank of New York wrote in this report that the shift toward central clearing and derivatives will add to the demand for collateral assets which is already being increased by reliance on secured bank funding, but noted there is no evidence or expectation of any lasting or widespread scarcity of such assets in a global financial market. But I think one of the key questions in this report was there will be elements of collateral short falls from a geographic stand point. Maybe you can shed a little light into that.  

Yu: Sure. Why don’t we take a step back and talk about where the concerns around collateral crunch are really coming from. And a lot of it is being driven by regulations. Specifically the need for mandatory central clearing, which is going to rely on new collateral postings that were in the past never really required before. So new collateral requirements for corporates as well as counterparties that are swept up under the EMIR regulations as well as the Dodd Frank regulations. And what that’s really going to push is the need for high quality collateral. And the concern really around that was that with all the new demand for high quality collateral and only a finite amount available, there would be a lot of folks chasing the same pool of eligible collateral.

Now what this report is really talking about is that their study has shown that there is not going to be a long term scarcity of collateral. And there is a mention that in the short term there may be some supply and demand imbalances and what I think we really mean when we talk about the short term effects is really the countries that have less healthy financial health are going to have problems collecting and getting high quality collateral, given that they are already posting collateral for a lot of their day to day funding needs.

Jockle: So mainly that’s going to put us right smack in the middle of the Eurozone.

Yu: Exactly. So some of the peripheral countries like Greece and Italy, the ones who have potentially weaker sovereign bonds for posting of collateral may find that they’re taking higher haircuts on their own collateral and will need higher grade collateral situation such as US Treasuries which everybody else is chasing to be able to post and meet collateral requirements.

Jockle: Well one of the evolutions of eligible collateral talked about AAA and AA government backed issuance and most notably out of these countries, we’re starting to see the more widespread acceptance of covered bonds as higher rated securities. So are we seeing a structured finance 2.0 on the horizon?

Yu: That could be a discussion in itself. The fact that some of the ratings requirements are being minimized so that bonds are actually getting pushed through, with less requirements and less stringent in standards. And it reminds me of the time pre subprime crisis when bonds moved through that chain of ratings very quickly and were put out into the market for public issuance and public consumption in a very short time frame without necessarily all the due diligence. That concerns me in one sense in that we’re putting out a lot of new securities that may not really hold the rating that has been issued.

Another concern is collateral transformation which is really the ability for banks to offer services to essentially re-hypothecate or re-use the existing collateral to be posted elsewhere. So that creates a interdependency where one piece of collateral is not only used to be posted for one pool of assets but it may be used to pool against multiple pools of assets and so you have interdependency between multiple counterparties, multiple banks that this report actually talks about that potentially being another financial concern of collateral transformation.

Jockle: So let’s go back to the original collateral shortfall. One of the clear issues in central clearing, or the fear factor was around initial margin. Now that initial margin as we’re starting to reemerge in what is appearing to be a bull market, one can assume initial margin costs are going to coming down a little bit. So how is that taking off some of the pressures on collateral management?

Yu: I think, we can’t necessary breathe a sigh of relief that initial margins are going to go away. So initial margin is here to stay, central clearing is here to stay. Institutions that were not required to clear before will now have to clear and post margin, and what that means is that they need better frameworks  in place to be able to anticipate collateral needs so that really brings into what we’ve been seeing in the last year or two around OTC derivatives central clearing.

A lot of institutions have been speaking to us about how to predict or forecast the collateral needs for whether they’re going to use a bilateral counterparty for transacting or centrally clearing it, there are going to be different initial margin considerations and that is also part of the optimization that’s being done to help in the decision making process whether you centrally clear, does that give you better collateral margin requirements than to have it bilaterally traded.

Jockle: And that brings us right back to funding questions. Denny thank you so much for your time and this is going to be something that we continually watch as collateral and the collateral shortfall or lack thereof continues to evolve. We want to hear what you think. Follows us on twitter @nxanalytics. Follow our blog. We will be talking a little bit more about this and definitely we’ll have Denny back on the video again. Denny thank you so much and we’ll see you next time.

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