How Corporate Treasurers Can Cope with the Challenges of Collateral
by Anthony van Eden, Director: Strategic Projects – Strate
One of the functions of a corporate treasurer within a financial institution is to raise or manage working capital and invest surplus funds to support the business. Banks borrow from and lend to one another, and they normally place collateral for each of these bilateral agreements. Cash is a key component within the process, closely followed by liquidity management. However, in the near future, the introduction of new regulations aimed to protect the financial markets from systemic risk has raised concerns that legislation could place pressure on high-quality liquid assets, such as cash.
Regulations will impose stricter guidelines on how liquidity and risk is managed and the impact is being felt by both local as well as international institutions. Basel III, for example, requires banks to hold more regulatory capital (the minimum capital requirement as demanded by the regulators that a bank must hold in order to operate), as well as greater high-quality liquid assets on their balance sheet. Under these rules, which will be phased in by 2019, banks must hold sufficient liquid assets to cover all net cash outflows under a stress scenario for 30 days and be able to fund assets maturing after a year with stable funding sources. Similarly, Solvency II will be introduced to regulate insurers and call for increased solvency capital ratios. This affects the availability of cash in the market to be used as collateral on a market-wide basis.
In addition, the Group of Twenty Finance Ministers (G-20) recommends that all standardised OTC derivatives should be centrally cleared with central counterparties (CCPs). Central clearing of derivatives traded bilaterally in over-the-counter (OTC) markets is set to become more widespread. This would place CCPs between the counterparties of all such bilateral transactions, so they would become sellers to every buyer and buyers to every seller, and thus take on the counterparty credit risk of the bilateral trades. 
Since OTC derivatives currently often do not carry initial margin, counterparties will now have to place cash as collateral with CCPs, which will have a further impact on the availability of cash in the market. In addition, non-cleared OTC derivatives have to also be collateralised. Now, counterparties have to place margin when they didn’t have to before.
This will prove to be a challenge for corporate treasurers that need to enhance liquidity and manage credit risk.
Challenge for corporate treasurers
Cash is known for being a high-quality asset that is fungible (which in itself carries counterparty credit and settlement risk) and easily transferable within the current banking system. How can corporate treasurers optimise their working capital and collateral, now that they may need to place more cash as collateral? The answer is simply to find an alternative asset to use as collateral.
Some corporates are already using a small percentage of bonds and equities in addition to cash as collateral. Research  shows that over 80% of collateral is made up of cash, while securities (equities and bonds that are regarded to be high in quality and meet strict standards) make up the remaining percentage. Institutions globally have considered the greater use of high-quality eligible equities and bonds in addition to cash as collateral and several South African institutions are looking to follow suit.
While the combined use of cash and securities as collateral seems to be a solution, financial institutions face yet another obstacle – the administratively intensive burden of managing these bilateral agreements or the investment in technology, infrastructure and support to implement an automated solution.
Collateral agreements are bilateral in nature and it is common to re-use collateral received against other financial exposures. However, the current bilateral nature brings with it limitations, such as the incomplete overview of placed and received collateral, as one counterparty can only ‘see’ their collateral as far as their direct counterpart. There is uncertainty relating to the location and size of the collateral as well as to how it can be traced throughout its movements. This incomplete view becomes a concern for the market. It is this lack of visibility of the size and location of collateral placed and the inefficient use of collateral, and the build-up of collateral silos across financial products also leads to inefficient use of collateral or over-collateralisation.
Furthermore, daily margin and collateral calls as a result from the mark-to-market of the collateral, corporate actions and capital events, manual collateral allocations and substitutions and the management of eligibility criteria contribute to a strenuous and manually intensive administration process. Many institutions find the operating risk and the administrative burden to be a costly exercise as a result.
Collateral management is not a core business operation of many corporate treasurers who tend to rely on the collateral management systems and margin calls of the counterparty financial institution. Furthermore, there is an opportunity cost relating to idle collateral on corporate balance sheets. There are often lower returns generated by cash used for collateral. The opportunity to optimise available collateral across all of one’s counterparties without a holistic view does not yet exist within South Africa to view each counterparty’s eligible collateral arrangements with each of their counterparties, and those counterparties’ counterparties, and so on.