Funds - the next evolution in collateral management
Mohamed M'Rabti, Deputy Head of FundsPlace and Head of ETFs, Euroclear
Traditional sources of collateral are shrinking and there is increasing demand for alternative types of collateral to fill the gap.
Where this alternative collateral resides and how it can be used was central to a number of debates at Fund Forum International in June, this year.
Global regulations, ranging from Dodd-Frank and EMIR to Basel III, to name but a few, have forced institutions to hold greater amounts of high quality assets.
As a consequence of the desire to prevent further public bailouts of financial firms and the consequent capital demands made on them, market participants have seen cost pressures rise and revenues stagnate.
There is now huge demand in the market to collateralise more trades and more efficiently than in the past.
Collateralisation moves centre stage: the funds advantage
With worldwide assets under management by the investment funds industry expected to exceed $100 trillion by 2020, according to PwC, Asset Management 2020 - A Brave New World, the investment industry has an opportunity to position its products as a valid and, potentially, more efficient alternative to cash, government securities and other types of collateral.
Of course, not all instruments are acceptable to counter-parties and industry standard-setters. As a rule, assets used as collateral have to be liquid, need to be easily priced and should have diversification benefits in order to mitigate concentration risk. Many money market funds and ETFs fall into this definition, as do a number of mutual funds.
As long as the funds have look-through attributes, so that collateral takers can assess exactly what they are exposed to, they have the potential to be acceptable to regulators and collateral takers.
The advantages over cash, for example are clear. An asset manager pledging a fund as collateral faces a cash re-investment risk. That is, if the custodian cannot reinvest the cash at a sufficiently high interest rate, the asset manager could incur a loss.
However, if the cash collateral is transformed into, say, a money market fund, the re-investment risk is greatly reduced.
What are the challenges?
While the theory is simple enough, there are some potential practical challenges to using funds as collateral.
The first is regulatory constraints on how collateral can be sourced and used. However, this challenge is not limited to funds and should not be a significant impediment to using funds as collateral.
The second is to establish exactly what types of collateral are eligible under existing regulation and industry standards, and how these rules can be applied to funds.
While this question has vexed capital markets participants for years, it should be said that industry securities lending body, the International Swaps and Derivatives Association (ISDA), which represents beneficial owners, provides fairly comprehensive information.
The next challenge is whether funds should be pledged or transferred. Pledged collateral can only be re-used with the permission of the giver of collateral, whereas transferred collateral can be used however the receiver chooses.
Many broker-dealers are exploring the use of pledge structures as opposed to transfers in order to achieve better capital treatment for transactions.
The structure depends on the transaction. In the case, for instance, of initial margin on non-cleared OTC derivatives, the collateral is pledged. In the case of a repo transaction, the answer is likely to be a transfer.
The funds industry is more geared towards pledged structures, which may create issues with some transactions, but certainly does not reduce the opportunity to any great extent.
Potential catalysts for greater use of funds
Although employing funds as collateral is likely to be a growth area in transactions, to date it is relatively rare. The issue comes down to good old supply vs demand.
That is, banks are prepared to accept funds as collateral if their fund management clients wish to offer them. But in many cases, fund managers simply don’t consider it.
Why is this?
Principally, because securities lending is seen as an esoteric activity by many fund managers and few resources are devoted to exploring the issue. As a consequence, most of them tend to offer traditional types of collateral and banks therefore are not prepared to devote time and effort to creating and expanding structures that allow for funds as collateral.
In addition, regulators are not currently rushing to get involved. They have been busy for a number of years reforming the capital markets, including imposing rules on collateral management, and their instinct is to stand back.
It is therefore up to the funds industry, including its representative associations and advisers, to drive the issue forward.
Only a sustained program of education about the benefits of using funds as collateral will increase supply, which will subsequently stimulate demand.