Collateral evolution
04 November 2014
Collateralisation trends continue to evolve, finds Tim Keenen of BondLend
Image: Shutterstock
Whether collateral efficiency, optimisation or upgrade, the securities finance markets give rise to the use of collateral in a number of ways. In light of increased capital charges, reduced leverage and decreasing netting opportunities as a result of changing regulations, the way firms use collateral continues to evolve.
Within securities finance exists a general collateral market as well as a specials, or intrinsic value, market. The general collateral market allows dealers to effectively fund their long positions with cash investors looking for a safe, collateralised investment alternative. The risk reduction in these types of transactions is typically handled by the haircut to the price of the underlying collateral. Yet although dealers will have high-grade collateral to fund, they will also find themselves with less-liquid collateral that needs to be financed, too.
Many cash investors will look at a range of collateral types to enjoy an increase in yield on their investments as they go down the credit curve. Risk is mitigated by imposing higher haircuts on the lesser-credit-quality collateral. This dynamic allows a dealer to fund the spectrum of securities while the cash investor enjoys yield enhancement and risk mitigation through margin.
Another efficient way to fund is in the securities finance specials market. Traditionally, specials borrowed and loaned in the securities finance market have been collateralised by cash. However, over the last several years, we have seen an increase in the desire by dealers to provide non-cash collateral along with agent lenders willing to accept it.
Across securities finance transactions globally, we have seen increasing demand on EquiLend and BondLend among lenders to accept non-cash collateral from their broker-dealer trading counterparts. DataLend’s aggregated market data affirms this as well, depicting the growth in the use of non-cash collateral over the past year (see Figure 1).
In the fixed income market, these trades are known as bonds borrowed transactions, where a lender is willing to lend a bond and take another bond as collateral. The equity equivalent is an equity-for-equity transaction, where lenders will lend an equity and accept another equity as collateral. These trade types—often collectively referred to as collateral upgrade trades—are nothing new to securities finance market participants. But the steady increase in the use of non-cash collateral may be a sign that their use is on the rise.
Another possible explanation for this changing dynamic is the fact that broker-dealers have been obliged to pare down their balance sheets under new and upcoming regulations. One route to accomplish this is by broker-dealers funding their borrows with non-cash rather than cash collateral.
As for lenders, their increased willingness to accept non-cash collateral may be due to potential cash market volatility. Liquidity in the cash markets is not always sufficiently available, particularly in volatile market environments. As a result, lenders may be seeking other types of collateral, which could be less susceptible to such volatility, to facilitate their lending.
These non-cash collateral types include the range of instruments, with varying credit quality, mentioned above. As a borrow is executed against non-cash collateral, this mitigates the need for a rebate because the payment becomes a fee from the borrowing broker-dealer. This allows the lender to avoid market fluctuations in rates on cash reinvestments that can occur in some market environments. By imposing a fee, market participants know exactly what their earnings will be and are not dependent on a specific cash reinvestment rate.
This form of collateralisation has particular appeal to broker-dealers, too. It allows broker-dealers to use their long inventory specifically to collateralise their borrowing needs. The use of non-cash collateral by broker-dealers allows them to efficiently optimise their long portfolios while still effectively borrowing or financing their short positions.
As collateral management and optimisation become increasingly important for institutions around the globe, we expect to see collateralisation trends continue to evolve in the securities finance market
Within securities finance exists a general collateral market as well as a specials, or intrinsic value, market. The general collateral market allows dealers to effectively fund their long positions with cash investors looking for a safe, collateralised investment alternative. The risk reduction in these types of transactions is typically handled by the haircut to the price of the underlying collateral. Yet although dealers will have high-grade collateral to fund, they will also find themselves with less-liquid collateral that needs to be financed, too.
Many cash investors will look at a range of collateral types to enjoy an increase in yield on their investments as they go down the credit curve. Risk is mitigated by imposing higher haircuts on the lesser-credit-quality collateral. This dynamic allows a dealer to fund the spectrum of securities while the cash investor enjoys yield enhancement and risk mitigation through margin.
Another efficient way to fund is in the securities finance specials market. Traditionally, specials borrowed and loaned in the securities finance market have been collateralised by cash. However, over the last several years, we have seen an increase in the desire by dealers to provide non-cash collateral along with agent lenders willing to accept it.
Across securities finance transactions globally, we have seen increasing demand on EquiLend and BondLend among lenders to accept non-cash collateral from their broker-dealer trading counterparts. DataLend’s aggregated market data affirms this as well, depicting the growth in the use of non-cash collateral over the past year (see Figure 1).
In the fixed income market, these trades are known as bonds borrowed transactions, where a lender is willing to lend a bond and take another bond as collateral. The equity equivalent is an equity-for-equity transaction, where lenders will lend an equity and accept another equity as collateral. These trade types—often collectively referred to as collateral upgrade trades—are nothing new to securities finance market participants. But the steady increase in the use of non-cash collateral may be a sign that their use is on the rise.
Another possible explanation for this changing dynamic is the fact that broker-dealers have been obliged to pare down their balance sheets under new and upcoming regulations. One route to accomplish this is by broker-dealers funding their borrows with non-cash rather than cash collateral.
As for lenders, their increased willingness to accept non-cash collateral may be due to potential cash market volatility. Liquidity in the cash markets is not always sufficiently available, particularly in volatile market environments. As a result, lenders may be seeking other types of collateral, which could be less susceptible to such volatility, to facilitate their lending.
These non-cash collateral types include the range of instruments, with varying credit quality, mentioned above. As a borrow is executed against non-cash collateral, this mitigates the need for a rebate because the payment becomes a fee from the borrowing broker-dealer. This allows the lender to avoid market fluctuations in rates on cash reinvestments that can occur in some market environments. By imposing a fee, market participants know exactly what their earnings will be and are not dependent on a specific cash reinvestment rate.
This form of collateralisation has particular appeal to broker-dealers, too. It allows broker-dealers to use their long inventory specifically to collateralise their borrowing needs. The use of non-cash collateral by broker-dealers allows them to efficiently optimise their long portfolios while still effectively borrowing or financing their short positions.
As collateral management and optimisation become increasingly important for institutions around the globe, we expect to see collateralisation trends continue to evolve in the securities finance market
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