The Cosmetics of Collateral Transformation

Responding to the new regulatory reforms such as the Dodd-Frank Act in the US, banks are now marketing “collateral transformation” services. A good source for various materials on this issue is Tracey Alloway’s coverage in FT Alphaville.

What are these services? How are they connected to the reforms? Should we be worried?

Collateral transformation is a fancy name for a particular type of loan, as shown in the top three boxes of the figure below. A company/fund trading a standardized derivatives contract cleared by a central counterparty (CCP) must post a margin. Initial margins are posted with cash and government securities; variation margins are posted with cash. Holding cash for the purpose of posting margins exacts an opportunity cost, for it earns less than if invested in less liquid securities. The bank steps in and offers to lend the company/fund the cash for collateral at the CCP, and the company/fund provides less liquid securities it holds in the balance sheet to the bank as collateral. In addition to providing the company/fund with liquidity, the bank structures the arrangement to easily mesh with the mechanics of trading, settlement and so on, so as to minimize the administrative costs to the institutions that are its customers. See this brochure and this article.

Dealer banks have always been providing credit and liquidity to customers trading derivatives with them. But this credit and liquidity was implicitly bundled inside the non-margined trades. Clearing forces the dealers to unbundle the two as separate services. Now the derivative itself must be cleared and margined, so that minimal credit risk attaches to the derivative. But the institution trading the derivative still needs the credit that it previously got from the dealer bank, and collateral transformation services are that credit. The bank assumes some credit risk from the counterparty, but it’s the same credit risk that was a part of the non-margined derivative, now explicitly itemized and booked separately. It’s a new look for an old face.

Collateral transformation services are the type of innovation that the financial reforms call for. In it banks to continue lending and assuming credit risk arising from customers’ derivative trades.

However, collateral transformation has made some analysts wary and voice warnings of the potential dangers to come:

1. Collateral transformation loads bank portfolios with loans backed by illiquid securities.  The liquidity mismatch between cash extended to customers and the collateral received can become combustible if the market value of collateral posted with the bank drops at the same time that the customers’ derivatives trades lose value and customers need to draw down on their credit line with the bank. This makes it more difficult for the bank to secure repo funding for its loan commitments.

2. Banks’ habit of demanding thin haircuts in good times and fat haircuts in bad times (pro-cyclical collateral) contributes to excessive volatility, bubbles and crises.

3. In their quest for ever higher returns, banks might increase their reliance on low-quality collateral.

4. OTC brokers’ portfolios tend to be more or less matched. Collateral transformation now available to many buy-side firms (pension and investment funds) with highly directional positions will make banks’ commitments unbalanced and more exposed.

Many of these concerns are valid.

However, none constitute new dangers to the banking system, and all of them can be managed if banks follow proper practices. It is the banker’s choice to perform due diligence and decide whether to provide the service to a client, to ask for buffers, to classify what assets can be accepted as collateral, and to manage haircuts.

Regulators also need to do their jobs and monitor how likely clearing members face liquidity shortages in the event repo markets dry up. In theory, collateral transformation should facilitate their job as the credit lines extended become more open and explicit than they currently are in the OTC markets.

Well…things may not be so simple.

Once the dealer gets the securities it has the incentive to re-use them in many different ways to boost its returns beyond the commissions paid by the corporation for the collateral transformation services. As the bottom section of the figure shows, upon receiving the securities from the corporation, the dealer can exchange them into higher yield assets through swaps, sell them outright and invest on a cheaper synthetic through derivatives and get additional leverage. In all these transactions the dealer is taking higher risks, as well as counterparty risk. And remember that when the corporation decides to close the derivatives trade in the CCP, it returns the cash to the dealer, which in turn is obligated to give the securities back to the corporation. Because the investments made by the dealer do not match the securities that have to be returned to the corporation, the dealer is exposing itself to additional risks and can face big problems.

The issues presented by collateral transformation services are similar to those raised by synthetic ETFs, and both have already attracted regulators’ scrutiny—see here and here. The recent $2.3 billion trading loss at UBS involving the desk managing synthetic ETF exposure has added fresh urgency to regulators’ concerns.

Is the solution to brokers excessive risk taking and their inability to satisfy the enormous demand for cash associated with the transition into margined derivatives contracts, to make CCPs accept non-cash variation margins and allow trades to use broader types of collateral? No! This is definitely an idea to avoid. CCPs must be insulated from counterparty risk as much as possible, leaving the screening and handling of these risks to be done outside the CCPs.

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