Collateral shortage unlikely with clearing, says LSE/DTCC paper
A collateral shortage is unlikely to materialise although firms could struggle to obtain collateral, according to a study by the London School of Economics (LSE), in conjunction with the Depository Trust & Clearing Corporation (DTCC).
The paper – “The Economics of Collateral” – by Ronald Anderson and Karin Joeveer cautions market participants that access to collateral could be limited following implementation of mandatory clearing of over-the-counter (OTC) derivatives through central counterparty clearing houses (CCPs). This limited access to collateral, said the report, can be attributed to regional and product-focused market infrastructure, varying regulatory policies across markets, fragmentation at firm-levels and across local jurisdictions, and CCP product specialisation.
CCPs are only allowed to accept high quality collateral – usually cash or government bonds – for initial margin while firms can only post cash collateral for variation margin. “There is a risk that swaps clearing could facilitate a collateral shortage or lead to collateral being trapped in CCPs. One way to mitigate the risk of a collateral shortage is for CCPs to accept lower grade collateral like AAA rated corporate bonds in exchange for a higher haircut,” said Mark Jennis, managing director for strategy and business development at the DTCC.
Whether or not regulators permit CCPs to accept lower grade collateral remains to be seen. Patrick Pearson, head of market infrastructure at the European Commission, has repeatedly warned CCPs that a race to the bottom on collateral quality would not be looked upon kindly by regulators. Expanding the eligibility criteria for collateral could expose CCPs, many of which do not possess strong balance sheets, to enormous risk.
“If a CCP decides to reduce its collateral requirements because of a collateral shortfall in the market, it would be done so carefully and in a risk averse way. They would be very careful in the collateral they accept. Furthermore, I suspect some CCPs would prefer to have high grade corporate bonds posted as margin as opposed to lower credit quality sovereign bonds, for example,” said Jennis.
The study highlighted the fragmentation of market infrastructure could also lead to a collateral shortfall. A bank clearing trades across four markets with a single integrated counterparty could experience a near 10-fold increase in margin movements if these were cleared through four separate CCPs. “That firms will have multiple CCP relationships means collateral could be hard to obtain and post per the various CCP margin deadlines. This could be especially true during volatile periods in the market, when CCPs could be forcing clearing members to post margin intra-daily,” commented Jennis.
The study advised market participants and infrastructure providers to collaborate on technical solutions to ensure streamlined access to collateral. “For several years, there has been much debate on a collateral shortage. Our research has found that the challenge does not lie in the global supply of collateral in aggregate, but rather in the accessibility of collateral across markets and participants. The search for new methods to alleviate bottlenecks and seamlessly allocate collateral is the next challenge for infrastructure providers and participants. Collaboration between participants and infrastructure providers will be crucial to ensuring an efficient process,” said Ronald Anderson of the LSE.
Hedge funds which do not have this collateral at hand will be required to go to their prime brokers, which will turn ineligible collateral into eligible collateral for a fee in what is known as a collateral transformation upgrade. One of the core attractions of mandatory OTC clearing to prime brokers was that they originally thought they could be gross to the market and net to the clearing house in a collateral sense. Now, the Commodity Futures Trading Commission (CFTC) has nixed that and the ability to re-hypothecate excess collateral has shrivelled up.