Collateral: banks, broker-dealers, funds and clearinghouses all need it more than ever. Collateralization of bilateral as well as cleared OTC trades is essential to ensure a functioning and stable financial market that is able to absorb potential shocks of Lehman-esque dimensions. Upcoming regulations like Basel III, Dodd-Frank and EMIR and margin requirements for non-centrally-cleared derivatives will enlarge the required collateral pool considerably.

Isn’t there plenty of collateral available already? Not exactly! Estimates from various sources suggest that the additional collateral necessary to cover the rising demand is between $2 trillion and $4 trillion. With cash collateral being the most expensive but also most successful option (i.e. being fungible, reusable and easy to manage operationally) the expansion of collateral types under consideration as part of the Basel Capital Adequacy Consultative document will see an increased use of diverse collateral (eligible instruments like government bonds). This change will lead to new requirements like complex collateral valuation tools.

But there is currently a squeeze on what is acceptable collateral in today’s volatile trading environment. This could make maintaining collateral an expensive proposition. Long gone are the days where there was plentiful high-grade sovereign debt available. The International Monetary Fund predicts that sovereign downgrades will reduce the supply of general collateral by $9 trillion by 2016.

Clearing houses, looking for alternatives, are starting to also accept gold bullion and high-grade corporate bonds but this is only the tip of the iceberg. Clearing brokers are offering their clients collateral transformation services to swap non-eligible assets into cash, albeit at a cost.

As a consequence financial market participants need to re-evaluate the way they are performing collateral management today. A siloed approach to collateralisation looking at collateral for repo, listed products and OTC products separately for example, won’t work in the future. It is essential to use available collateral to your best advantage but this is only possible if there is a holistic company-wide view on collateral management, as close to real-time as possible.

Collateral management needs to be viewed not as a cost centre but rather as a provider of an invaluable service to the trading function and to clients alike. Moving along the maturity model stages collateral management might even become a profit centre by utilising re-hypothecation, optimised collateral/netting as well as collateral ‘upgrade’ trades. Next week our OTC clearing blog series will look at reporting requirements to trade repositories and the unintended consequences in this area.

Authors: Kersten Martin Meyer and Tom Riesack