Collateral management became a survival tool for financial firms trading over-the-counter derivatives as regulators mandated central clearing and highly liquid instruments for initial variable margins. Collateral transformation—the art of turning illiquid assets into usable margin—was born as they reached for assets to back their trades, and became a profitable service business for a handful of pioneers. Now, other firms are eyeing the business.
According to the Bank of International Settlements (BIS), an estimated 70% of the total annually traded volume of OTC contracts will be centrally cleared this year, creating a collateral requirement of between US$4.7 trillion and US$5.3 trillion. With eligible assets in short supply at many firms, the need to post more and updated margin with a central body put a premium on efficient use of collateral. While some firms are learning to free up eligible assets by shuffling their portfolios, many remain significantly short of meeting their margin requirements.
To fill this gap, a dozen firms including custodians, dealers, and settlement houses are currently offering to convert ineligible assets into usable ones. Essentially, these collateral transformation facilities enable clients to post illiquid securities that the intermediary swaps into cash in the repo and securities lending markets before posting it with the central counterparty clearing houses (CCPs) that ended one-on-one OTC derivative trades by individual firms.
Following the example of the pioneers who have led the pack in designing transformation tools since the regulatory reforms, other financial institutions would do well to explore whether and how they can effectively leverage their existing capabilities to offer collateral transformation services to clients.
Succeeding in this market requires more than an ability to transform collateral via repo and securities lending markets or access to highly liquid assets, however. For example, the technological undertaking is not a simple one. Firms must have an architecture that combines data management, automation of flexible business rules, collateral-matching algorithms, performance analytics, risk measurement, monitoring and reporting.
On the sell side, firms aiming to transform illiquid assets into margin must get a handle on which markets they can best compete in, and what potential clients’ needs are. Before jumping in head first, they should create client-specific business cases, mapping them against markets of various sizes to assess their own possible penetration and market share. From there, firms should identify any gaps and potential roadblocks to offering these services to specialized teams within a firm, such as systems and analytics, risk, and compliance.
On the buy side, no one size of collateral transformation model fits all players; the partnership model if chosen should be commensurate with each firm’s understanding of the market, risk appetite, and the workings of collateral partnerships. Finally, firms should only turn to collateral transformation after making sure they have already used their existing assets as efficiently as possible, which remains a cheaper option.