Squaring the collateral triangle
20 August 2019
David Lewis, of FIS, discusses how regulations will have more of an effect on our business now, and in the near future, than they have ever before
Image: Shutterstock
Regulations have always shaped our industry, that is their nature. However, it is probably fair to say that they are having more of an effect on our business now, and in the near future, than they have ever done before. Many column inches have been written about Securities Financing Transactions Regulation (SFTR), and now we are on the road to implementation in April 2020, the new requirement for the securities finance industry to report to a regulator is finally on the horizon. SFTR is, of course, all about transparency and bringing the world of shadow banking out into the sun, delivering on the Transparency Directive handed down by the Financial Stability Board (FSB). Combine the effect of SFTR with other forces at play in our market, including the other new regulations coming into force or already in place, then we see an influence on the market that is much wider than perhaps the original individual requirements intended.
Looking at a number of these regulations, a common thread becomes evident. Just like many other segments of the financial markets, regulators are looking to regulate out risk as far as is possible—in the same way, health and safety commissions look to protect the public from harm. Risks cannot be eradicated, of course, because without it, returns make little sense; but they can be minimised, and this is what a number of regulations are aiming at. Central Securities Depositories Regulation (CSDR), Fundamental Review of the Trading Book (FRTB), the various incarnations of Basel and, of course, SFTR, all have common factors either directly or indirectly affecting the way collateral is managed or reported.
The need for additional capital under Basel III has driven many banks to reorganise their balance sheets as they move to meet the new requirements applied to them. This has had an effect on the securities finance market as borrowers look for high-quality liquid assets (HQLA) to improve their balance sheets. However, in a report by the European Banking Authority (EBA) on the progress of Basel III implementation released this month, it is indicated that across the 189 banks questioned, the capital requirements would rise by an average of 24.4 percent. This translates, in the report’s terminology of “conservative assumptions”, to a capital shortfall of some €135 billion, including €91 billion of common equity tier one. Looking at large global banks, it is clear that they are carrying the larger part of this increased obligation, as medium-sized banks are looking at an average rise of just 11 percent of the capital or around €1 billion. Small banks fare even more favourably at just 5.5 percent and around €100 million of additional capital required.
In its recommendations, the EBA advises that Basel III reforms are introduced by the European Commission with regard to the “calculation of exposure values of counterparty credit risk exposures stemming from securities financing transactions (SFTs)”. This would suggest that the need for HQLA is unlikely to be diminishing any time soon.
In an article, published by the Financial Times on 22 May 2019, Manmohan Singh, a senior economist at the International Monetary Fund, explained how collateral velocity is once again on the increase. Collateral velocity, first measured effectively in 2011, is the ratio of the total pledged collateral received by large banks that is eligible to be reused, divided by the primary collateral sourced from financing activities, including repo, securities lending, prime brokerage and derivative margins. In simpler terms, the ratio indicates the level of reuse of collateral due to financial intermediation between banks and non-banks, something regulators are keen to understand, and which can be seen reflected in some of the data requirements we see in SFTR.
Having dipped significantly from around three in 2017, velocity was calculated at around 2.5 between 2010 and 2011, immediately post the Lehman default and the ensuing financial crisis. Collateral velocity continued to fall, dipping to a low of 1.8 in 2016 as regulations and a general aversion to counterparty risk saw collateral pledged fall from $10 trillion to around $6 trillion. It could also be argued that quantitative easing by several central banks was also sucking up a lot of HQLA supply. Since 2016, however, it has been on the rise: two in 2017 and 2.2 in 2018. This has been caused by a growth on both sides of the equation but with primary collateral rising by only around 10 percent, while the volume of pledged collateral has grown more than three times as fast at 33 percent. While this rise has only closed half the gap that was created by the financial crisis, it does put pledged collateral back over the $8 trillion level.
But what does all this mean to the securities finance industry? The rise in primary collateral has been driven primarily by securities lending and prime brokerage activity, reflecting the additional activity in collateral sourcing and supply to meet regulatory changes. It is also indicative of market participants changing the way they trade in order to stay within new balance sheet constraints. What may follow is a loosening of those pressures as central banks begin to reduce the size of their balance sheets and free up the HQLAs that they have taken from the market. Certain central banks have undertaken securities lending programmes themselves, which have muddied the waters somewhat, but that will be offset by the reduction in the quantitative easing programmes.
The impact of FRTB has also been felt across the market as capital is allocated towards illiquid assets, and market participants have pushed away from holding anything they cannot efficiently price. This regulation is another potential demand on the capital of banks, bringing further pressure to the market. It is a regulation that is, arguably, easily defended on the basis that it is not unreasonable to expect a bank to hold capital to secure an asset that does not meet a fairly low bar on asset pricing. Anyone who has seen ‘The Big Short’ will understand the knock-on effect of mispricing illiquid or distressed assets. Such requirements certainly uphold the health and safety objectives of the regulators when they are considering the security of the financial markets.
With multiple regulations bringing numerous layers of complexity to the capital and collateral requirements of the financial markets, the securities finance industry finds itself firmly in the crosshairs, not least because as of April 2020 we will need to be able to report comprehensively on collateral traded and its level of reuse. The roll-out of margin requirements for uncleared derivatives will be another major driver of change, requiring either the posting of additional collateral by hundreds of more counterparties or the move into the clearinghouses.
In either case, the objective of protecting the end consumer and the stability of markets is being addressed. All we need to do now is find all that extra collateral and optimise it across all our businesses.
Looking at a number of these regulations, a common thread becomes evident. Just like many other segments of the financial markets, regulators are looking to regulate out risk as far as is possible—in the same way, health and safety commissions look to protect the public from harm. Risks cannot be eradicated, of course, because without it, returns make little sense; but they can be minimised, and this is what a number of regulations are aiming at. Central Securities Depositories Regulation (CSDR), Fundamental Review of the Trading Book (FRTB), the various incarnations of Basel and, of course, SFTR, all have common factors either directly or indirectly affecting the way collateral is managed or reported.
The need for additional capital under Basel III has driven many banks to reorganise their balance sheets as they move to meet the new requirements applied to them. This has had an effect on the securities finance market as borrowers look for high-quality liquid assets (HQLA) to improve their balance sheets. However, in a report by the European Banking Authority (EBA) on the progress of Basel III implementation released this month, it is indicated that across the 189 banks questioned, the capital requirements would rise by an average of 24.4 percent. This translates, in the report’s terminology of “conservative assumptions”, to a capital shortfall of some €135 billion, including €91 billion of common equity tier one. Looking at large global banks, it is clear that they are carrying the larger part of this increased obligation, as medium-sized banks are looking at an average rise of just 11 percent of the capital or around €1 billion. Small banks fare even more favourably at just 5.5 percent and around €100 million of additional capital required.
In its recommendations, the EBA advises that Basel III reforms are introduced by the European Commission with regard to the “calculation of exposure values of counterparty credit risk exposures stemming from securities financing transactions (SFTs)”. This would suggest that the need for HQLA is unlikely to be diminishing any time soon.
In an article, published by the Financial Times on 22 May 2019, Manmohan Singh, a senior economist at the International Monetary Fund, explained how collateral velocity is once again on the increase. Collateral velocity, first measured effectively in 2011, is the ratio of the total pledged collateral received by large banks that is eligible to be reused, divided by the primary collateral sourced from financing activities, including repo, securities lending, prime brokerage and derivative margins. In simpler terms, the ratio indicates the level of reuse of collateral due to financial intermediation between banks and non-banks, something regulators are keen to understand, and which can be seen reflected in some of the data requirements we see in SFTR.
Having dipped significantly from around three in 2017, velocity was calculated at around 2.5 between 2010 and 2011, immediately post the Lehman default and the ensuing financial crisis. Collateral velocity continued to fall, dipping to a low of 1.8 in 2016 as regulations and a general aversion to counterparty risk saw collateral pledged fall from $10 trillion to around $6 trillion. It could also be argued that quantitative easing by several central banks was also sucking up a lot of HQLA supply. Since 2016, however, it has been on the rise: two in 2017 and 2.2 in 2018. This has been caused by a growth on both sides of the equation but with primary collateral rising by only around 10 percent, while the volume of pledged collateral has grown more than three times as fast at 33 percent. While this rise has only closed half the gap that was created by the financial crisis, it does put pledged collateral back over the $8 trillion level.
But what does all this mean to the securities finance industry? The rise in primary collateral has been driven primarily by securities lending and prime brokerage activity, reflecting the additional activity in collateral sourcing and supply to meet regulatory changes. It is also indicative of market participants changing the way they trade in order to stay within new balance sheet constraints. What may follow is a loosening of those pressures as central banks begin to reduce the size of their balance sheets and free up the HQLAs that they have taken from the market. Certain central banks have undertaken securities lending programmes themselves, which have muddied the waters somewhat, but that will be offset by the reduction in the quantitative easing programmes.
The impact of FRTB has also been felt across the market as capital is allocated towards illiquid assets, and market participants have pushed away from holding anything they cannot efficiently price. This regulation is another potential demand on the capital of banks, bringing further pressure to the market. It is a regulation that is, arguably, easily defended on the basis that it is not unreasonable to expect a bank to hold capital to secure an asset that does not meet a fairly low bar on asset pricing. Anyone who has seen ‘The Big Short’ will understand the knock-on effect of mispricing illiquid or distressed assets. Such requirements certainly uphold the health and safety objectives of the regulators when they are considering the security of the financial markets.
With multiple regulations bringing numerous layers of complexity to the capital and collateral requirements of the financial markets, the securities finance industry finds itself firmly in the crosshairs, not least because as of April 2020 we will need to be able to report comprehensively on collateral traded and its level of reuse. The roll-out of margin requirements for uncleared derivatives will be another major driver of change, requiring either the posting of additional collateral by hundreds of more counterparties or the move into the clearinghouses.
In either case, the objective of protecting the end consumer and the stability of markets is being addressed. All we need to do now is find all that extra collateral and optimise it across all our businesses.
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