In the wake of the 2008 global financial crisis, it seems regulators wholeheartedly agreed with the Oracle of Omaha. Much of the regulation that followed, was aimed at reducing counterparty risk - a great deal of which was a consequence of uncollateralized derivative activity - as well as shoring up capital positions in investment banks once viewed as too big to fail.
The upshot has been regulation mandating the use of collateral in almost all derivatives transactions. Because this collateral must meet strict eligibility criteria, the logical hypothesis across the industry was that we would face a ‘collateral squeeze’ i.e. a surplus of demand, thus making collateral more expensive and derivatives less attractive from a profitability perspective. Whilst there is greater demand upon collateral than ever before, the predicted shortfall never really happened, which is not to say it isn’t just around the corner.
Let’s quickly outline the key requirements upon collateral before moving on to reasons why cost-to-source has not shot up.
Since 21 June 2016 in the EU the clearing obligation (EMIR article 4 in the EU & section 723 of Dodd-Frank in the US) mandates clearing of Interest Rate Derivatives contracts (with a distinction between which instruments are mandatory depending upon whether the denomination is G4 or not) and Credit Default Derivative contracts. Like bi-lateral margining, this is a phased implementation. CCPs call both Variation Margin and Initial Margin from both sides of the trade, so the mandatory clearing obligation would logically affect the amount of collateral available in the market. Additionally, from March of this year, non-clearable OTC derivative trades also carry with them the obligation to exchange margin bilaterally. At the moment, this applies to Variation Margin for all market participants with Initial Margin requirements being phased-in to extend to the whole market by 2020.
With stringent eligibility criteria, why are we not seeing a shortfall in collateral?
Firstly, the phasing of Initial Margin requirements and clearing obligations means that only a very few participants are required to exchange Initial Margin bi-laterally this year. Many firms are not actually exchanging Variation Margin because they haven’t managed to put together margining processes in time.
On the sell-side, banks have materially shrunk the size of their balance sheet, so the amount of collateral required has been at least offset with a reduction in business, freeing up collateral naturally. In addition, both buy-side and sell-side firms are working the asset side of their balance sheet much harder, utilizing unencumbered assets, releasing trapped cash and centralizing their collateral management. This realizes significant efficiency gains and frees up more collateral.
Collateral and off-balance sheet trading (e.g. upgrading to HQLA, synthetics rather than on balance sheet structures) remain highly popular and effective routes to sourcing eligible collateral or reduce the need for HQLA as capital or liquidity buffers. So, firms who do need to source collateral, are finding ways of satisfying their requirements without pushing the price up.
Many firms also responded to the regulatory desire to de-risk derivatives by turning to more esoteric and exotic products. Clearly an unintended consequence because it contaminates the balance sheet with low quality, high risk, high return trades but, as margins are compressed, and the cost of trading on balance sheet increases, trading desks are trying to replace lost revenue potential.
The consensus is that the predicted collateral squeeze hasn’t materialized.
As mentioned previously, that doesn’t necessarily mean that there won’t be a collateral squeeze. Most on the buy-side are not yet exchanging Initial Margin, and won’t be caught until 2019-20. This phasing-in means we haven’t yet actually realized the full impact of margin requirements. The compression of balance sheets appears to have stopped and all firms have made material inroads into fully utilizing their unencumbered assets.
As such, the industry appears to have used its “spare capacity” and further increases in the need for HQLA may start to cause the long-promised squeeze. With the sell-side moving towards more exotic trading, one thing is clear – you can’t stop institutions from taking risk onto their balance sheet to maintain or grow their firm return of equity.
Did derivatives margin requirements throw the baby out with the bath water and move firms towards even more risky investments? Only time will tell but the introduction of risk mitigating collateral requirements was never intended to drive traders into riskier markets.