By John Arnesen, consulting lead, Pierpoint Financial Consulting

There has been a lot of commentary and debate surrounding collateral in general over the past few months, no doubt heightened by the preparation for Uncleared Margin Rules (UMR) and the impact on buy side firms that may, for the first-time, post securities collateral as initial margin. The wider implications of collateral management, the providers, optimisation and suitability has fueled some interesting discussion and none less so than at the Euroclear Collateral Conference earlier this month.

In the first panel at this event, a reference was made to unsecured financing and its balance sheet positive effects. While the estimated unsecured outstanding balance is estimated to be between USD 80-100 million, the panel agreed it was a trending feature and likely to grow. This got me thinking; imagine if an agent lent on an unsecured basis? How attractive would they be to a borrower in terms of all of the regulatory and internal costs savings they would reap?

Obviously, it goes without saying that it is highly unlikely this trend will ever permeate through to the traditional securities lending market. However, what could, and probably should happen is some deeper thinking by agents and their clients as to what type of collateral requirements would put their assets ahead of their peers when jockeying for position in a crowded and competitive market.

A little history

For many but not all agents, the origin of their European securities lending offering used USD cash as collateral with a 5% margin and subsequently reinvested by their colleagues in the U.S. This was certainly true of the early 1990’s but soon evolved into the taking of European cash against the currency of the loan for fixed income assets- in particular by some of the leading agent lenders, JP Morgan, BNY Mellon and Deutsche Bank to name a few. They developed their capabilities to reinvest the cash from desks in London or Europe during a period of wide spreads, specials, deep cheapest- to- deliver bonds and volatility.

Cash collateral has received its share of criticism since the Global Financial Crisis (GFC) and at other points in securities lending history, but is that criticism appropriate?

Cash as a form of collateral is a great common denominator. Neutral, highly liquid and centres the economics of the trade around the rebate, a reflection of the value of the borrowed securities benchmarked against the prevailing interest rate.

Cash collateral itself wasn’t the issue during the GFC, it was some of the reinvestment vehicle choices that were brought into question. The introduction of the euro saw a lot of consolidation in cash balances. Most clients required the lion’s share of their cash to be reinvested in reverse repo of Government debt and as that asset class became more expensive, cash started to lose its flavour, exacerbated by the experience during the GFC.

According to data from FIS Astec Analytics, cash collateral has rarely risen beyond 16% of outstanding government debt loan balances for many years. So, what is collateralising the EUR 200 billion of European Government debt in securities lending balances currently outstanding?

One thing is for sure, it’s unlikely to be the highest rated European Government debt. The demand for this collateral transformation is ideally a combination of banks’ regulatory need for HQLA as well as the financing of the collateral. The Liquidity Coverage Ratio (LCR) for example has driven demand for at least the past seven years but it isn’t the borrowed assets that drive the fee, it is the collateral. Under LCR, financing the collateral assets for a minimum of thirty days provides a favourable regulatory treatment for the collateral.

I recently asked a market practitioner” How much HQLA would you take unsecured?” His response, “all of it”. I then asked the same question but collateralised with German, French and Dutch debt. The response,” none” And against a basket of index equities, Italian and Spanish debt with a smattering of corporate debt his response was “as much as I have the collateral to post”.

This is the point. The HQLA transaction requires an acceptable collateral set that essentially finances the long assets of the borrower by posting them as collateral. This can be frustrating for an agent lender that has a client with vast holdings of HQLA but their collateral parameters do not permit anything beyond a narrow range of Government debt and excludes index equities. Participation in the above trade will be paltry at best. Another frustration can also present itself. The client may not only have a healthy portfolio of HQLA but also manages an array of equity funds, yet won’t take equities as a collateral asset class. Eliminating an asset class as a form of collateral while already investing in that asset class, runs the risk of leaving the HQLA sitting idle. Given the dominance of non-cash collateral it is those beneficial owners with broad collateral acceptability profiles that will lend their assets first.

Some years ago, I had a central bank client that approved certain equity indices as collateral and their utilisation of German and French debt reached 95%. The argument that this is poorly correlated is valid but the utilisation in a fully indemnified programme mitigated a lot of that risk. In today’s environment, for agent lenders to be able to indemnify all forms of non-cash collateral is key. This type of flexibility applies to equity markets in equal measure but there are beneficial owners with equity portfolios that will only accept government debt as collateral. Clearly, they could be considered in a right way risk position but their utilisation will be nothing like that of other participating beneficial owners and it would be disingenuous for them to grumble about performance on a comparative basis with their peers.