SLT: How do you see the securities finance market at the moment? Is the behaviour of participants markedly different to that seen five years ago? How important has risk management become to the industry?
Jo Van de Velde: Over the past few years we have seen a shift from a yield-driven to a risk-driven market. During earlier years, triparty collateral management was led by broker-dealers who were looking for an efficient and cheap way to finance securities. It’s now equally driven by cash lenders who are looking for safe ways to lend money. We’ve seen steady growth in the number of money market funds and large corporates using triparty services to invest their cash in a secure manner. Central counterparties (CCPs) are also becoming active triparty users to manage their core margining processes.
In terms of volumes, we saw a drop at the start of the crisis, but our volumes are already beyond pre-crisis levels. This is clearly the result of the move from unsecured to secured cash lending activity. Some firms made the decision to move to a secured model in a very short timeframe, and were able to do so easily because of the availability of triparty services.
What we’re also seeing is heightened risk awareness. Where there was a predominant focus on market risk, clients now increasingly focus on the types of collateral received, where it’s received, their rights to liquidate collateral and at what price, the risk taken on the agent, the risk on the margins and so on. Being able to re-use collateral and gain access to central bank liquidity, especially during turbulent market conditions, is also vital.
These issues are now reflected in the quality of collateral being used in triparty as there has been a clear shift in demand for higher quality and more liquid securities. In the interbank market, collateral quality is very high, where nearly 80 per cent is government bonds. Lesser quality paper is being used as collateral with the European central banks, where only 10 per cent of the 2 trillion euros of collateral deposited with the central banks are govies.
SLT: What value can an ICSD provide when it comes to managing risk?
Jo Van de Velde: We in-source all the operational work related to collateral management so that the banks can focus on risk management. We apply the haircuts, perform margins calls, automate collateral substitutions, and provide real-time reporting and more to keep banks informed of these activities. We understand the importance of being able to focus on risk management at times like now when the markets are volatile, and we value the reputation we have earned as a provider on which clients can depend to give them the freedom to manage these risks.
Clients don’t want to wonder if their assets are marked-to-market everyday, or about their collateral concentration risks. We make sure everything happens according to plan. For example, when Lehman went bust, market participants needed to rely on providers they could trust; we were tested along with other providers and we proved a success.
It’s only when you go through a crisis such as Lehmans that the model you employ for such situations can be improved. The test was not only on the triparty system specifically, but included all the actions we took to protect our clients. It was also a test for the industry - upon the declaration of a default, when could they start selling assets?
Counterparties were questioning what they needed to do. So, while our operational processes performed well, we have found areas to improve as a result of our Lehmans experience. We should point out that Euroclear Bank’s default management system proved to function as planned, and in the aftermath of the Lehman default our settlement volumes rocketed.
SLT: How does the work of ICSDs dovetail with what CCPs do in managing risks?
Jo Van de Velde: As a triparty collateral agent, we do not take on counterparty risks, whereas CCPs do.
As the clearing business continues to grow, so will the amount of collateral needed to be posted to CCPs. So, it’s important that a CCP is supported by a strong collateral backbone. Euroclear adds value in this context by supporting CCP margin calls, managing defaults, and the like to make the system even stronger.
Of course, there remains a possibility that a CCP will go bust, so it’s important that the margins are covered. If managed correctly and the CCP defaults, you’ll be able to get your cash or securities collateral back. Yet, with the amount of collateral that will be posted to CCPs, it is understandable that some clearing members will raise questions about the safety of their collateral in case of such an event.
Today, our triparty services are able to efficiently segregate collateral. And, we can easily act as a third-party pledge holder for the pledgor and pledgee, ring fencing the collateral risk for both parties.
SLT: Is tri-party collateral management the way of the future? Does it work for all markets to underpin all transaction types?
Jo Van de Velde: It is, most definitely. The beauty of a triparty service is that it allows you to centralise, standardise and optimise your collateral activities across markets and transaction types. The agent makes sure that collateral automatically moves in accordance with the underlying agreement governing collateral eligibility. It also allows both counterparties to keep control of the collateral management process without having to perform it – they can then focus on managing risks. And, the cost of collateral is reduced because asset allocations are optimised on a continuous basis.
SLT: Can you tell me more about the new term DBV service in the UK?
Van de Velde: Euroclear UK & Ireland has had a delivery-by-value (DBV) or triparty service for many years. But repos and the collateral posted had to roll over on a daily basis, which caused major liquidity swings every morning and required significant amounts of liquidity from the Bank of England and the settlement banks. This practice is not very efficient for the broker dealers that needed financing arrangements over a longer period. So, in June we launched a term DBV collateral system with an automated collateral substitution feature in the UK, which allows clients to post collateral for the life of the term transaction without having to roll it over everyday.
The duration of these transactions is, in theory, limitless - we’re already managing a one-year term agreement. Following the launch of this service in the UK, we have scheduled similar service launches in November for France, Belgium and the Netherlands.
SLT: How much of an impact are the new regulatory requirements having on your business?
Van de Velde: There is a lot of new regulation coming up - Dodd Frank and Basel III are just some examples. The main ones affecting us are the regulatory obligations that seek to reduce the banking industry’s dependence on short-term sources of funding. As our clients engage in longer maturity transactions, triparty collateral management will surely increase their operational efficiency.
More important is the clearing of derivatives transactions through CCPs, as we expect to see a huge need for collateral as a result. Most of the buy-side derivatives trades are directional. Apart from the initial margins that will have to be posted, the variation margins can also be significant. As buy-side firms are not necessarily sitting on cash or quality collateral, brokers will have to transform the buy-side’s collateral into CCP-eligible collateral. In addition, CCPs will need to mark-to-market collateral positions on a daily basis, and with today’s market volatility, possibly a few times each day.
Our triparty services already support intra-day margin calls and can facilitate the required collateral transformations. They can help clients implement new regulations without adding more operational risks and costs.
SLT: What trends are you witnessing in the securities lending segment?
Van de Velde: Beneficial owners have been increasing their awareness of risk and quite rightly demand more control when it comes to lending their assets. They are now questioning where their collateral is being held, even when working through an agent. We have seen how well the triparty system supports the beneficial owner’s needs. Agents still make money by managing the beneficial owner’s assets, but if they want to continue as an agent, they may expect some of the rules to change.
It’s also becoming clearer that EU regulation on short selling will mean that market participants will want more than ever to settle their trades on settlement date. Therefore, we expect an increase in demand for settlement-integrated securities borrowings to avoid settlement fails. Our automated lending and borrowing programme, which generates loans for securities deliveries that would otherwise fail, is likely to grow.
SLT: What are the key issues you are focusing on for the future? What trends are you seeing when it comes to collateral management?
Van de Velde: One point for sure is that the need for collateral is going to accelerate. Regulations are going to be imposed and everyone wants more protection and security. We need to ensure high collateral mobility, unlock new sources of collateral, such as loans, and help clients manage their collateral in the most optimal way.
With 22 trillion euros of collateral in the Euroclear group, we will focus on helping our clients gain access to all of the assets they hold with us to be used as collateral, no matter the Euroclear entity. We will also provide triparty collateral management services in the domestic CSDs of the group so that we can increase collateral management efficiency for clients in their home markets as well as for cross-border transactions through a single relationship.
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