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Perspectives

Collateral Demand: US$11 Trillion Opportunity

2015-02-17


As new Basel III norms, margin requirements and growing risk aversion, drive demand for high-quality collateral, there are ways to optimize this new currency in today's financial market.

One of the key drivers of the 2007—2009 financial market crisis involved large, insufficiently collateralized counterparty trade exposures. When major counterparties failed to settle trades on time, the trust deficit amplified causing a systemic meltdown. In the emerging post-Lehman financial environment, high-quality collateral will be the new currency for safeguarding against counterparty risk, meeting regulatory guidelines and buffering central bank balance sheets. In part one of our three-part series on collateral management, we discuss the dynamics that increase the need for collateral and best practices for overseeing it.

Navigating the New Currency

High-quality collateral is a money-like asset that doesn't depreciate with risk—whether tied to credit, duration or liquidity risk. In short, it is cash or any other fungible financial stock that can be exchanged for cash credit immediately, with a minimal haircut.

Figure 1

The Chicago Mercantile Exchange (CME), a leading derivatives trade exchange, has segmented the acceptable quality collateral universe into three broad categories: Cash with minimal haircut, followed by the U.S. Treasury and money market funds. Last year's margin survey by the International Swaps and Derivatives Association (ISDA) clearly identifies the use of cash and government securities as predominant collateral, constituting 91.1% of collateral received and 97.1% of collateral delivered. In this equation, cash accounts for 80% of the collateral used—reflecting heightened risk aversion.

While cash and government securities play a key role in collateralizing derivative trades, January 2014 statistics from the U.S. tri‑party repo market show a balanced collateral demand composition where Treasury ($571 billion), Agency securities ($637 billion) and Equities ($150 billion) constitute 85% of the market, with cost implications for highly liquid treasuries in a stabilizing market.i

Demand Drivers to Soak Up US$11 Trillion

According to the Treasury Borrowing Advisory Committee (TBAC), the estimated cumulative incremental demand for high-quality collateral will range between $2.6 trillion and $5.7 trillion under normal market conditions and between $4.6 trillion and $11.2 trillion under a stressed market environment over the next five years.

Key demand drivers include:

  • Basel III: According to Bank for International Settlements (BIS) estimates, the liquidity coverage ratio provision under the new Basel III norms is expected to result in a cumulative collateral demand ranging from $1.0 trillion to $2.5 trillion between 2013 and 2019.
  • Derivative clearing: According to ISDA and CME, from 2013 in the U.S. and from 2014 in Europe, the initial margining needs of high-quality collateral for mandatory, exchange-based clearing of standardized derivatives will require between $0.8 and $2.0 trillion under normal market conditions and between $1.8 trillion and $4.6 trillion under stressed market conditions.
  • Margin requirements: ISDA estimates the initial margin and variation margin collateral demand for non-centrally cleared derivatives to be between $0.8 trillion and $1.2 trillion in normal market conditions and between $1.8 trillion and $4.1 trillion in a stressed market.

Shrinking Collateral Supply

The International Monetary Fund (IMF) estimates that between 2007 and 2011, the high-quality collateral made available to the street (large broker dealers) to meet the market demands by commercial banks, hedge funds, money market funds and securities lending operations fell from $10 trillion to $6.2 trillion.

According to the TBAC, there are other factors at play:

  • AAA/ AA assets: The primary issue of AAA/ AA assets is estimated to be US$2 trillion annually, for at least the next five years.
  • No rehypothecation: Negative impact of the "no rehypothecation" rule on supply is estimated to drain between $1.2 trillion and $2.4 trillion under normal conditions and $3.2 trillion and $7.6 trillion under stressed conditions.

The Demand-Supply Mismatch and Resulting Opportunities

While demand for high-quality collateral can be met comfortably in benign market conditions, the situation becomes a material challenge when the market is under duress. Also, in Europe, empirical evidence shows that these assets are unevenly distributed among core and peripheral countries. This resulting imbalance has already created interesting opportunities for collateral custodians such as Euroclear and Clearstream in Europe and tri-party repo in the U.S., to build collateral highways that address burgeoning demand and seek rent for their collateral under custody. For more insights, you can read our papers on the economic value of big data for global custodians (PDF) and the opportunities for custodians in the changing asset management arena (PDF).

To make the most of the swiftly changing environment, organizations must establish a comprehensive collateral management infrastructure to address portfolio margining, demand-supply gap, recordkeeping and regulatory needs, necessary communication standards and a robust reference data system.

For an in-depth analysis of the changes underlining today's financial markets, please read our paper The Collateral Conundrum: A US$11 Trillion Opportunity? (PDF). Do not miss part two and part three of our series on collateral management for a roadmap to optimize collateral and the crucial nature of margin requirements. Visit Cognizant's Capital Markets Practice for more.

Footnotes 

i http://www.newyorkfed.org/banking/tpr_infr_reform_data.html

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  • Basel III: According to Bank for International Settlements (BIS) estimates, the liquidity coverage ratio provision under the new Basel III norms is expected to result in a cumulative collateral demand ranging from $1.0 trillion to $2.5 trillion between 2013 and 2019.
  • Derivative clearing: According to ISDA and CME, from 2013 in the U.S. and from 2014 in Europe, the initial margining needs of high-quality collateral for mandatory, exchange-based clearing of standardized derivatives will require between $0.8 and $2.0 trillion under normal market conditions and between $1.8 trillion and $4.6 trillion under stressed market conditions.
  • Margin requirements: ISDA estimates the initial margin and variation margin collateral demand for non-centrally cleared derivatives to be between $0.8 trillion and $1.2 trillion in normal market conditions and between $1.8 trillion and $4.1 trillion in a stressed market.

Shrinking Collateral Supply

The International Monetary Fund (IMF) estimates that between 2007 and 2011, the high-quality collateral made available to the street (large broker dealers) to meet the market demands by commercial banks, hedge funds, money market funds and securities lending operations fell from $10 trillion to $6.2 trillion.

According to the TBAC, there are other factors at play:

  • AAA/ AA assets: The primary issue of AAA/ AA assets is estimated to be US$2 trillion annually, for at least the next five years.
  • No rehypothecation: Negative impact of the "no rehypothecation" rule on supply is estimated to drain between $1.2 trillion and $2.4 trillion under normal conditions and $3.2 trillion and $7.6 trillion under stressed conditions.

The Demand-Supply Mismatch and Resulting Opportunities

While demand for high-quality collateral can be met comfortably in benign market conditions, the situation becomes a material challenge when the market is under duress. Also, in Europe, empirical evidence shows that these assets are unevenly distributed among core and peripheral countries. This resulting imbalance has already created interesting opportunities for collateral custodians such as Euroclear and Clearstream in Europe and tri-party repo in the U.S., to build collateral highways that address burgeoning demand and seek rent for their collateral under custody. For more insights, you can read our papers on the economic value of big data for global custodians (PDF) and the opportunities for custodians in the changing asset management arena (PDF).

To make the most of the swiftly changing environment, organizations must establish a comprehensive collateral management infrastructure to address portfolio margining, demand-supply gap, recordkeeping and regulatory needs, necessary communication standards and a robust reference data system.

For an in-depth analysis of the changes underlining today's financial markets, please read our paper The Collateral Conundrum: A US$11 Trillion Opportunity? (PDF). Do not miss part two and part three of our series on collateral management for a roadmap to optimize collateral and the crucial nature of margin requirements. Visit Cognizant's Capital Markets Practice for more.

Footnotes 

i http://www.newyorkfed.org/banking/tpr_infr_reform_data.html

Read Cognizant Perspectives on your iPad!
Get the app today! >>

  • Basel III: According to Bank for International Settlements (BIS) estimates, the liquidity coverage ratio provision under the new Basel III norms is expected to result in a cumulative collateral demand ranging from $1.0 trillion to $2.5 trillion between 2013 and 2019.

  • Derivative clearing: According to ISDA and CME, from 2013 in the U.S. and from 2014 in Europe, the initial margining needs of high-quality collateral for mandatory, exchange-based clearing of standardized derivatives will require between $0.8 and $2.0 trillion under normal market conditions and between $1.8 trillion and $4.6 trillion under stressed market conditions.

  • Margin requirements: ISDA estimates the initial margin and variation margin collateral demand for non-centrally cleared derivatives to be between $0.8 trillion and $1.2 trillion in normal market conditions and between $1.8 trillion and $4.1 trillion in a stressed market.

Shrinking Collateral Supply

The International Monetary Fund (IMF) estimates that between 2007 and 2011, the high-quality collateral made available to the street (large broker dealers) to meet the market demands by commercial banks, hedge funds, money market funds and securities lending operations fell from $10 trillion to $6.2 trillion.

According to the TBAC, there are other factors at play:

  • AAA/ AA assets: The primary issue of AAA/ AA assets is estimated to be US$2 trillion annually, for at least the next five years.

  • No rehypothecation: Negative impact of the "no rehypothecation" rule on supply is estimated to drain between $1.2 trillion and $2.4 trillion under normal conditions and $3.2 trillion and $7.6 trillion under stressed conditions.

The Demand-Supply Mismatch and Resulting Opportunities

While demand for high-quality collateral can be met comfortably in benign market conditions, the situation becomes a material challenge when the market is under duress. Also, in Europe, empirical evidence shows that these assets are unevenly distributed among core and peripheral countries. This resulting imbalance has already created interesting opportunities for collateral custodians such as Euroclear and Clearstream in Europe and tri-party repo in the U.S., to build collateral highways that address burgeoning demand and seek rent for their collateral under custody. For more insights, you can read our papers on the economic value of big data and the opportunities for custodians in the changing asset management arena.

To make the most of the swiftly changing environment, organizations must establish a comprehensive collateral management infrastructure to address portfolio margining, demand-supply gap, recordkeeping and regulatory needs, necessary communication standards and a robust reference data system.

For an in-depth analysis of the changes underlining today's financial markets, please read our paper The Collateral Conundrum: A US$11 Trillion Opportunity?. Do not miss part two and part three of our series on collateral management for a roadmap to optimize collateral and the crucial nature of margin requirements. Visit Cognizant's Capital Markets Practice for more.

Footnotes 
i http://www.newyorkfed.org/banking/tpr_infr_reform_data.html

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Collateral Demand: US$11 Trillion Opportunity