Collateral squeeze unlikely to materialise
The so-called collateral shortfall is unlikely to be as severe as some market participants initially believed although obtaining high-grade eligible collateral to post as initial and variation margin to central counterparty clearing houses (CCPs) could become more challenging.
The Bank of International Settlements (BIS) has estimated up to $4 trillion of high-grade eligible collateral may be required over the next few years once more OTC derivatives are cleared through CCPs as mandated under Dodd-Frank in the US and the European Market Infrastructure Regulation (EMIR). This could be exacerbated further by the implementation of bilateral margining of non-cleared derivatives in 2015.
“The first collateral shortfall predicted by various market participants has failed to surface as yet. That said, a lot of the regulations have been postponed, although the introduction of mandatory clearing has not led to collateral shortages. Nonetheless, I do believe there will be a ‘collateral pinch’ whereby high grade collateral is harder to come by,” said Jeannine Lehman, EMEA head of Global Collateral Services at BNY Mellon.
These thoughts were echoed in a paper – The Economics of Collateral – produced by the Depository Trust & Clearing Corporation (DTCC) in conjunction with the London School of Economics. The paper said the introduction of mandatory clearing might limit market participants’ access to collateral. 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.
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. The study advised market participants and infrastructure providers to collaborate on technical solutions to ensure streamlined access to collateral.
The challenge of obtaining collateral is, however, unlikely to result in CCPs lowering their eligibility criteria for initial and variation margin. “Regulators will not permit it, and CCPs will not want to expose themselves to added risk,” said Lehman. 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. Service providers, namely banks, are offering firms collateral management services. Meanwhile, it was announced last week that Euroclear and the DTCC would create a joint venture to enable each other’s customers to access their collateral pools, which hold $43 trillion in assets under custody.