What is Euroclear’s global Collateral Highway and what does it do?
One of the consequences of the financial crisis is a distinct change in market behaviour and regulator focus on mitigating risk. The use of securities as collateral is and will continue to play a key role in accomplishing this objective and in the recovery of our financial markets. Basel III, Solvency II, the US Dodd-Frank Act and the European Market Infrastructure Regulation (EMIR) will impose tough risk management requirements, which will only increase demand for collateral. There is, however, a limited amount of available collateral. As a result, there is a predicted collateral shortfall, which early estimates put as high as $6 trillion.
Euroclear Bank is opening its infrastructure to help the market efficiently manage collateral flows while anticipating the challenges ahead for the market in managing potential collateral shortages. Whether or not there will be shortages, we already know that collateral management could be more efficient. Market participants too often find that the right collateral is in the wrong place when they need it.
Euroclear’s global ‘Collateral Highway’ sources securities to be used as collateral from multiple locations, which are the Collateral Highway entry points, including Euroclear Bank, all of the Euroclear central securities depositories (CSDs), agent banks and other CSDs, irrespective of time zones. These securities are then automatically routed via the Collateral Highway to the right place at the right time, whether it is to a central bank, a central counterparty (CCP) or to another counterparty to cover exposures arising from a repo or derivatives trade. We have developed sophisticated technology to track, transform and mobilise collateral across geographic locations.
Important features of the Collateral Highway are its flexibility, open nature and proven capabilities. It is designed based on Euroclear Bank’s existing collateral management infrastructure, so it has been quick to deliver while minimising development costs.
You mentioned ‘transformation’ of collateral—what is this and why it is so important?
Banks are facing two big challenges: first, many sovereign debt issues are being downgraded, so the securities that are held by banks are also losing their quality status; and second, the move to a centrally cleared OTC derivatives market is driving collateral demand upwards, meaning that banks with previously adequate collateral reserves may no longer be equipped with enough of the right collateral to cover their daily activities.
Collateral transformation enables banks and other financial institutions that do not have the appropriate type of collateral in their portfolios to borrow high-grade securities from institutions that actually have stockpiles of such assets, using their lower grade securities as collateral. Sovereign debt, corporate bonds and equities are increasingly used to guarantee the loan.
Collateral transformations make sense for both sides of the deal. For example, cash-rich institutions are depositing their cash balances with a network of banks, but usually only to the maximum amount that is guaranteed by the local authorities. In some markets, negative interest rates mean that they are actually paying the bank to hold on to their cash. An attractive alternative for such institutions is to enter the world of collateral transformation, offering part of their cash reserves or high-grade securities in exchange for lower-grade collateral at an attractive rate of return.
What would you say is the main driver behind Euroclear’s Collateral Highway?
There are two drivers. One is the changing nature of how financial institutions trade with each other. After the experiences of Lehman Brothers and MF Global, the level of confidence and trust between banks and other financial institutions has diminished considerably, which we have seen in the shift from unsecured to secured transactions. On top of this, the increased use of CCPs is adding to demand for collateral to cover initial and variation margins.
The second driver is regulation. Regulators on both sides of the Atlantic are pushing through ambitious legislative changes that will affect the way that financial firms do business. For some, it will mean a complete reassessment of their business models. A common theme resulting from the proposed legislation is the increased need for collateral to comply with the new regulations.
As mentioned previously, there may be a collateral shortage, which we are anticipating. However, the need to optimise the use of collateral for a growing number of purposes is already very important to our clients. Today, for any given firm, collateral is spread across various depositories and agents, as well as geographic locations. So, while the market needs fast access to quality collateral, it is not easy to mobilise the right collateral to the right place because of collateral fragmentation within various silos. The Collateral Highway alleviates this challenge.
Do you believe there will be a collateral shortage or is it overstated?
There is no certainty regarding future collateral scarcity. But the risk of insufficient supply of the right collateral is real. We wouldn’t be surprised to see the quality criteria of CCP-acceptable collateral potentially being relaxed in the near future. In fact, there are already two examples of this trend this year, which suggests that the market is aware of the potential high-grade collateral shortfall. The CME decided in April 2012 to increase individual clearing member collateral allowances for “(A-)” rated corporate bonds from $300 million to $3 billion. In the same month, LCH.Clearnet announced that it would be taking on Ginnie Mae mortgage-backed securities as collateral.
Today, we believe that a sufficient amount of collateral exists to meet current demands, but finding and mobilising the right collateral to the right place at the right time can be a Herculean task. We strongly believe the market would benefit from a global infrastructure serving as the backbone to source, transport and transform, if needed, securities from pools of collateral that are held anywhere and everywhere.
Why don’t banks create their own infrastructures and collateral management capabilities?
Many firms already manage collateral themselves, and are using triparty agents to optimise their use of collateral. However, as collateral demands increase, the complexity of tracking, sourcing, mobilising and transforming collateral cannot be understated. Only the biggest global banks and international central securities depositories (ICSDs) have the infrastructure to manage this process efficiently.
The alternative of purchasing a software suite from one of the software providers remains an option. But the budget that banks will need to spend is considerable. The most basic of these solutions will cost in the region of €300,000. If a bank wants more advanced or sophisticated operating features, the price is rapidly going to rise to between €800,000 and €1 million. And again, this is just for the software licence.
Integration of the software into the bank’s existing systems also costs money. The software will need to interact with trade capture systems, reference data systems, agreement repositories (GMRAs and so on.), to name but a few. Estimates suggest that full integration of the software suite can cost up to ten times the initial cost of the software itself. So, for a top-end system, plus integration and staffing, a bank would be looking at €10 million.
Banks selecting this option would still need to plan how to move collateral seamlessly across borders and to various collateral takers on a timely basis.
Which firms are connected to the Collateral Highway and what are your aspirations for it?
Discussions are still ongoing with a number of investment banks and capital market infrastructure providers, but there have already been several successful agreements with financial firms regarding the use of our global Collateral Highway. For example, BNP Paribas Securities Services became the first agent bank to join the Collateral Highway in Europe. This type of cooperation is likely to be more prevalent for our industry in the future as it offers mutual clients a greater level of collateral optimisation by combining the best of both worlds—in this case, Euroclear Bank’s triparty collateral management services accessed via the Collateral Highway and BNP Paribas’s in-house collateral management offer.
Further afield in Asia, the Central Money Markets Unit of the Hong Kong Monetary Authority has also joined the Collateral Highway. In this instance, it was a case of the domestic market needing to expand across borders to access foreign trading counterparties—something that has facilitated the expansion of cross-market renminbi funding activities and further strengthened Hong Kong’s role as the global hub for offshore renminbi business. Here, Euroclear’s Collateral Highway was a perfect way to align domestic needs with the increasing international appetite for renminbi activity. If we look across the Atlantic, the Federal Reserve Bank in the US is also on board, using the Collateral Highway to take on collateral from commercial banks, thus helping to manage liquidity in the market.
The future looks bright for the Collateral Highway. Central banks and CCPs are expected to continue to be the biggest consumers of securities collateral, and given the amounts of collateral that are required, it is important that the market has a systemic and open solution to maximise collateral availability and mobility across borders 24 hours per day. As Euroclear already has a proven collateral management infrastructure, relationships with more than 90 central banks and CCPs, and the ability to facilitate the transformation of ineligible collateral into central bank and CCP-eligible collateral, our Collateral Highway can be leveraged easily and efficiently.
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