A race to the bottom in collateral terminology refers to the potential for a downward spiral to occur in the acceptable quality of collateral to be posted at CCPs (central counterparty clearinghouses). Individual eligibility criteria at each CCP, which are operating as competitive, for profit entities, added to an anticipated collateral shortfall in the market, is resulting in very real fears of a race to the bottom taking place.
How bad any race to the bottom becomes, if it even becomes a reality at all, depends upon how big the collateral shortfall is. Whilst the exact number is an unknown, with estimates widely ranging from around $500 billion to $8 trillion, there is, by and large, a consensus that there will be a collateral shortfall; that there exists insufficient quality collateral to satisfy the post-crises regulatory environment.
In the event of a collateral shortfall, how will market participants be able to margin their positions at CCPs? CCPs will be taking initial and variation margin to offset the risk of a potential default in a trade, acting as it does as a buyer to every seller and a seller to every buyer. If one party cannot make good on its position, the CCP will step in and complete the transaction, utilising that clearing participant’s margin and default fund to do so.
If market participants cannot obtain eligible criteria to post as margin in order to clear, then what can they do? Clearing will soon be unavoidable, standing as it does as one of the central tenets of the G20 response to the post-2008 financial crises that swept through global financial markets.
CCPs are competitive entities and there is a possibility – a fear, even – that they will lower their collateral standards in order to facilitate client clearing, helping them to win new business.
Market participants have a number of collateral demands placed upon them now, and knowing where their assets are and what they can be used for, is crucial from a competitive view point. If assets are ineligible, then market participants can undergo a collateral transformation process; changing ineligible collateral into eligible collateral.
“Something has to give,” says John van Verre, global head of custody at HSBC Securities Services. “Either collateral transformation will have to become very, very efficient, or the acceptable standards of collateral will have to drop.”
With transparency and safety being two of the buzzwords about the shift to mandatory clearing, it is counterintuitive to allow the acceptable standards of collateral to drop. Regulatory interference in this area at the CCPs, as well as how they should be capitalised, are two outstanding questions to be resolved as mandatory clearing approaches. Whilst there are capitalisation rules in existence, the structure and adequacy of the default waterfall - how collateral posted as margin will be used and to what to degree - remains a topic for discussion.
“Collateral management is one of the biggest challenges facing our clients,” continues van Verre. “They need to know where their assets are and how they can be utilised. With central clearing they must appoint a clearing broker who accesses a CCP – keeping track of assets is not a straightforward two-way relationship. They must also work out how to most effectively use this collateral and if needs be, what they can most efficiently transform, bearing in mind that their assets are not just to be assigned to CCPs.”
The demands on collateral are, seemingly, ever increasing. Exchange traded derivatives have been collateralised since time immemorial, but the shift to clearing and margining over the counter derivatives is where the bulk of the demand will now come from. Aside from cleared OTC transactions, there are also non-cleared OTC transactions that will need collateral posting against them as well. The non-cleared world will be a more expensive place than the cleared one, too.
Portfolio margining and compression at CCPs is one way of reducing the demand for collateral at CCPs. Compression is, in effect, very similar to netting, so while it clears up the balance sheet, it may not result in much reduction for collateral requirements.
Another collateral demand being faced by the market comes from the FSAP (the Financial Sector Assessment Programme) from the IMF (International Monetary Fund). One of the FSAP recommendations is the central clearing of repo transactions. If all repo transactions are to be run through CCPs, then you would, in a lot of cases as regards collateral transformation, be collateralising the collateral – the demand for collateral would rise even further, making the shortfall greater. Central clearing of repo transactions is already way, LCH.Clearnet runs a repo clearing arm for example, but if it were to be extended to mandatory status, the collateral demands would be vast.
With this in mind, where is the supply of collateral coming from? There is an estimated $60 trillion of government debt in issue. This, clearly, is enough to cover any shortfall, a few times over. But the debt being in issuance and the debt being readily available for use as collateral are not the same thing.
A lot of government bonds have been purchased by central banks as part of the quantative easing process. As an example, it is estimated that the Bank of Japan, operating in an economy that is just coming out of a 2014 recession, will own 40 per cent of Japanese Government Bonds by the end of 2016. All quantative easing is achieving, in some cases at least, is the monetisation of debt, since central banks are buying up government bonds from banks in exchange for cash. The central banks are unlikely to lend out these purchases to participants in CCPs.
As you can see from the below chart, which represents the percentage of the industrialised world which is operating at or even below 0 per cent Policy Rates, there is not a lot of new government debt in issuance.
How can market participants get hold of the government bonds from central banks? Well, they cannot. The vast majority of government bonds are held by parties that have no intention of lending them out. The collateral models that are operated by firms like Euroclear and Clearstream will have to make the cost of lending them out very attractive. The knock-on effect of this is that the cost of borrowing would increase, making the cost of collateralising OTC trades too expensive to make the trading activity viable.
The CCPs themselves are aware of this. A recently published paper from LCH.Clearnet, Stress This House: A Framework for the Standardised Stress Testing of CCPs makes no mention of collateral. As soon as collateral is factored in, it makes the calculations impossibly complex and would have to rely upon the use of government debt. If equities ere to be an acceptable form of collateral, then their inclusion in stress testing will weaken those CCPs that accept them.
So those central banks and pension funds that are holding government bonds are unlikely to be willing to put them up for use at CCPs, since there are no guarantees as to the safety of the clearing model.
Whilst there are options available to market participants in regards of collateral transformation and compression, the most cost efficient way of posting collateral is to post what you have available at that time. As CCPs compete, it will be very tempting for them to start accepting lower quality, more illiquid collateral; especially if the high quality government debt is inaccessible.
If a CCP finds itself in a position where it has to liquidate a clearing participant’s collateral in order to make good a trade, then it will need highly liquid collateral in order to do so – government bonds fall under this category for countries such as the US and the UK. Until such a time of market stress, the requisite liquidity of the collateral remains unknown. We will not know how great the collateral shortfall is, or how far the race to the bottom has been run, until clearing participants start to default.