Risk has an interesting article ($) on the plans by some dealers to offer “collateral transformation” services to derivatives end-users. Requiring most derivatives to be cleared means that end-users will have to post daily variation margin to the clearinghouse (or “CCP”). Here’s how Risk describes the problem:
The problem centres on the type of collateral required by CCPs — or more specifically, the fact that many end-users don’t hold enough of it. Clearing houses only accept cash for variation margin, and usually insist on cash or sovereign bonds for initial margin. However, many buy-side users of derivatives tend not to invest in these assets — at least, not in the amounts that might be necessary.So the plan is to concentrate liquidity risk at the dealer banks? Gee, what could possibly go wrong?
...
Clearing members [i.e., the dealers] say they have a solution. ... [C]learing members are responsible for collecting margin from their clients and posting it to the clearing house, charging a fee for the privilege. As an additional service, however, a number of clearing members are also planning to offer collateral transformation facilities — essentially, enabling the client to post non-eligible instruments with the dealer, which will be switched into cash via the repo market and then posted with the CCP.
In all seriousness though, this is something that regulators should pay very close attention to. It’s easy enough* for dealers to tell regulators that their exposure is limited because the agreements are “unconditionally revocable” — that is, the dealer can unilaterally refuse to fund the client’s variation margin if the markets get too rough, and can demand that the client put up the cash. But it’s not nearly as easy for the dealer to tell its big hedge fund and pension fund clients to take a hike during a crisis. Think about it. If, say, Morgan Stanley refuses to fund a client’s variation margin call when the markets get volatile, the client will (a) be pissed, and (b) will start thinking, “What’s going on here? Is Morgan Stanley having trouble accessing the repo markets? If they can’t fund themselves in the repo markets, how much longer can they stay in business? Shit, I better pull my prime brokerage account at MS.” Then the run begins.
I’m not saying that no dealer would ever be able pull the trigger and refuse to fund a client’s variation margin. I’m just saying that this kind of arrangement could very easily turn into a non-contractual commitment to meet clients’ variation margin calls during a crisis. And that would undermine the dealers’ inevitable argument about how the unconditionally revocable nature of the arrangements means that the liquidity risk would be pushed back onto the clients — and away from the dealers — during a crisis.
So what should regulators do about “collateral transformation”? Well, for one thing, they should treat collateral transformation very harshly in Basel III’s Liquidity Coverage Ratio (LCR). Since these arrangements would almost certainly be structured as unconditionally revocable, they would be considered “Other Contingent Funding Liabilities” under the LCR. The run-off rate for “Other Contingent Funding Liabilities,” which determines the size of the liquidity buffer the dealers would have to hold against their collateral transformation arrangements, has been left to the discretion of national regulators. In addition to the run-off rate, national regulators also have to come up with assumptions for how much clients’ variation margins could move against dealers in the LCR’s 30-day stress scenario.
The safest route would be to set the run-off rate at 100% — that is, to assume that the dealers will fund 100% of clients’ variation margin through their collateral transformation services. A 75% run-off rate would probably be appropriately prudent as well — dealers will probably be able to say no to at least some clients, and will likely come up with other ways to mitigate some of the risk to themselves.
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* Actually, drafting and negotiating these types of contracts is a fiendishly difficult and contentious process, but that’s neither here nor there.
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16 comments:
I have been meaning to read that article (its in my inbox at work) but your post confirmed that it contained exactly what I thought...
Couple of personal thoughts on this complex subject starting with some basics (please correct me if I am wrong on any of the below)
Collateral Upgrades in General - This more often than not will be a two step process. First the collateral (say a corporate) will be repo'd out for cash, from there the cash will then be used to borrow in a treasury (assuming treasuries are posted to the CCP for RWA reduction). In theory you could do straight collateral for collateral but that market is thin in the US, but pretty widely used in EUR (but mostly Eqty).
If this all is the case, the repo for cash will count towards the LCR at probably 100% (the weight of the corporate) and NSFR (so funding for 1Yr may be needed....). As far as I can tell though if it were collateral for collateral upgrade (corp for tsy) I think it may be covered in LCR, or at the very least it is open for interpretation.
Lastly I think that there are starting to be some rumblings of CCPs expanding their collateral schedule for high grade corporate bonds... this would ease a large amount of the stress in the market since most user would have bonds in their inventory (especially someone buying a CDS as a hedge on a bond they own... makes sense to accept the underlying asset). This of course has its own issues (what if the bonds accepted were LEH bonds?
Overall because of LCR these upgrades will be funded on term. If the CCPs do not expand their schedule, the demand for term upgrades will sky rocket further increasing costs of using derivatives. At what point does it no longer become economical?
All of the above is based off of what I am reading and my interpretation so if anyone disagrees please correct me.
I may be crazy, or too stupid for this discussion entirely, but this looks to me like just a way for investment banks to charge more fees so as to shuffle things around under other names, that will wind up accomplishing and protecting nothing.
Lynn -
Yes and no.. it certain is a way to charge fees... but the amount of risk that must be taken is often not going to be worth the fees. Collateral upgrades as a result of new regulations, as well as CFTC rules is going to extremely expensive for the bank and as a result expensive for clients. Its not a service that I imagine will be wildly used.
If it was cheap / easy to use ultimately yes it would just be shuffling around... but at the end of the day arguably thats all wall st does... efficiently (or not) allocate the proper resources where they need to be.
At the end of the day, if all rules stand as they are... this is a great opportunity for the government because everybody and everything will require government bonds, LOTS of them.... The original Basel III draft didn't mention the credit banks get for having cash reserves, they only mentioned Gov't bonds.. seems odd that cash is no good, only Gov't (us and strong sovereigns). So that giant reshuffling will be everyone searching for cash or treasuries.
As for the protection aspect, the users of derivatives that require upgrades (pension funds, insurance companies, etc) will be safer in this model, but it yet again concentrates more risk with the banks.
Thanks, Anonymous. All I know is, anything connected to the word "transformation" always smells like a rat. The only other thing I am sure of is: there's debt, and this is either solid, or bad; and equity, where you pays your money and you takes your chances. Either way you have to be careful not to be taken advantage of. If it goes much past that, my eyes glaze over.
I think transformation is just being used since the technical terms for it isn't fully defined... is it a repo (repurchase agreement?) is a collateral upgrade? does anything happen at all? We will know a lot more as the final rules for OTC derivatives are considered before year end
In the author's original posting on CDS clearinghouses and their possible dangers, he uses the example of AIGFP, but he makes a grievous, grievous error by suggesting that the problem with AIGFP was that they collateralized their CDS.
The problem was LOSSES, not collateral. AIGFP insured fraudulent CDOs that were ultimately worth dimes on the dollar. They simply could not withstand the loss.
Exchanges are built on the principle that trades are statistically uncorrelated and the underlying economic relationships are heterogeneous to some significant extent. They also assume that there is no trader so large that his losses could bring down the system if he can't make good.
The problem with a CDS exchange is clearly that the real exposure of any given player is going to be too large and too correlated to other players and that the system is intrinsically unstable. Either balance sheets are large and liquid enough to deal with significant CDS losses or they're not. The dangers of collateral transformation suggest to us that they simply are not and that this insurance is intrinsically mispriced.
In the author's original posting on CDS clearinghouses and their possible dangers, he uses the example of AIGFP, but he makes a grievous, grievous error by suggesting that the problem with AIGFP was that they collateralized their CDS.
The problem was LOSSES, not collateral. AIGFP insured fraudulent CDOs that were ultimately worth dimes on the dollar. They simply could not withstand the loss.
Exchanges are built on the principle that trades are statistically uncorrelated and the underlying economic relationships are heterogeneous to some significant extent. They also assume that there is no trader so large that his losses could bring down the system if he can't make good.
The problem with a CDS exchange is clearly that the real exposure of any given player is going to be too large and too correlated to other players and that the system is intrinsically unstable. Either balance sheets are large and liquid enough to deal with significant CDS losses or they're not. The dangers of collateral transformation suggest to us that they simply are not and that this insurance is intrinsically mispriced.
In the author's original posting on CDS clearinghouses and their possible dangers, he uses the example of AIGFP, but he makes a grievous, grievous error by suggesting that the problem with AIGFP was that they collateralized their CDS.
The problem was LOSSES, not collateral. AIGFP insured fraudulent CDOs that were ultimately worth dimes on the dollar. They simply could not withstand the loss.
Exchanges are built on the principle that trades are statistically uncorrelated and the underlying economic relationships are heterogeneous to some significant extent. They also assume that there is no trader so large that his losses could bring down the system if he can't make good.
The problem with a CDS exchange is clearly that the real exposure of any given player is going to be too large and too correlated to other players and that the system is intrinsically unstable. Either balance sheets are large and liquid enough to deal with significant CDS losses or they're not. The dangers of collateral transformation suggest to us that they simply are not and that this insurance is intrinsically mispriced.
I'll be ridiculous, or way too silly for this debate completely, nevertheless this particular appears in my experience just like merely a method for purchase banks to be able to cost more fees in an attempt to shuffle issues close to under other brands, that will wind up completing along with safeguarding nothing at all.
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Collateral Enhancements generally * That generally might be a a couple stage approach. Buy RS GoldInitially this assets (say a corporate) are going to be repo'd out and about for cash, after that the bucks are able to be used to acquire inside a treasury (accepting treasuries are generally submitted to the CCP intended for RWA decline). In theory you could do this straight assets regarding collateral nevertheless that will marketplace is slim in the usa, Cheap WOW Goldalthough very widespread throughout EUR (however mainly Eqty).
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