Published: November 04, 2013
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. [1]
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.
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 [2] 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.[[[PAGE]]]
There is a growing demand for more automated collateral management solutions, focusing on solutions that streamline processes and improve operational efficiencies. The focus and trend internationally is to adopt a single, independent, centralised market-wide collateral management system that manages the members’ pool of exposures against the members’ pool of available collateral to be placed and received.
This will help achieve the primary benefit of optimisation, which can only be realised internally and on a market-wide collateral pool, and not with collateral silos. With an effective automated collateral solution on a market-wide ‘pooled’ basis, corporate treasurers will be able to benefit from greater certainty of the location and size of their collateral as well as the prevention of any unauthorised use of collateral. Through the concept of pooling, the opportunity exists that through a series of substitutions among the multitude of counterparty relationships, there is no necessity to place more collateral into the collateral pool to cover the total exposures of all members to the collateral pool.
The enhanced visibility also reassures corporate treasurers that their assets are safe and as securities are held in safe-keeping accounts, known as segregated depository accounts (SDAs), that are segregated within a market-wide collateral pool, assets can easily be identifies as belonging to the rightful owners in the event of a bankruptcy or liquidation proceedings. These SDAs are held in an account at the Central Securities Depository (CSD) and not at a sub-register level.
Pooling is important because assets are visible and can immediately be available, improving optimisation and freeing up cash, while automatically values collateral, tracking corporate actions and entitlements. Should a party be over-collateralised, securities will automatically be returned to the rightful owner.
An offering has been designed to combine with current collateral management functions that may exist within institutions, becoming a complimentary service that improves profitability and efficiencies by using existing systems and processes, while complying with the region’s regulations to manage eligible dematerialised bonds, equities and money markets.
With the industry evolving, CSDs across the world have looked at a solution to enhance liquidity and help grease the financial system in the face of regulations wanting banks to hold on to high-quality liquid assets and concerns that collateral could be affected as a result.
A Liquidity Alliance was formed between global CSDs, namely Australia’s ASX, Brazil’s Cetip, Germany’s Clearstream, Spain’s Iberclear and South Africa’s Strate. This can help achieve the true optimisation of collateral as the widest possible collateral pools will be created and used without jeopardising individual and country-specific requirements.
These countries, through their CSDs, have adopted technology for their domestic markets. The Collateral Management solution aims to offer the service from the country’s CSD. This further enhances risk mitigation, as the CSD is a neutral and independent third party, which also marks dematerialised securities placed as collateral.
South Africa will implement its collateral management solution in November 2013, a market imperative that will assist corporate treasurers and the financial market free up liquidity and use high-quality equities and bonds as collateral to free up cash and continue enhancing working capital in the face of Basel III, Solvency II and international regulations that will financial institutions also need to comply with, such as Dodd Frank and European Market Infrastructure Regulation, when entering into international transactions.
The solution will automatically validate, allocate, substitute and optimise local collateral and records the securities made available and used to collateralise open financial exposures in the country’s CSD.
Notes
1. Source: BIS introductory note: http://www.bis.org/publ/work373.pdf
2. Research source: http://www.strate.co.za/publications%20media/ashleycollateralpresentation.pdf
How Thought Leadership Can Reduce the Cost of Sales by Patrik Havander, Havander & Partners A focused attention on the costs incurred by the global sales and marketing processes is becoming increasingly important for corporate banks and their transaction banking departments. While the client/bank relationship remains vital, research has shown that in fact relationship selling […]
