HQLA investment funds: an untapped collateral asset class?
History in the making
The centre of gravity for the collateral management industry continues to draw its participants towards greater transparency and new sources of liquidity.
The latest innovative development in the world of refinancing made history on 10 November 2016 when two banks – Société Générale CIB and Société Générale Prime Services – exchanged a basket of HQLA investment funds (1) – issued by Lyxor Asset Management – against cash, through Euroclear’s triparty repo mechanism.
By outsourcing the post-trade management of this repo transaction to a triparty agent, both counterparties were able to benefit from simplified processing on a basket of securities, rather than on a line by line basis, daily valuation of securities, related margin calls and substitutions in real time.
Upstream, the transactions were carried out via Elixium, Tradition group’s new electronic trading platform, which is dedicated to repo and collateral management.
The raison d’être of the new platform is innovative as it anticipates a future state where a European collateral stock exchange will become a key component of the financial markets.
The five stakeholders of Elixium have developed the platform to facilitate the different processing requirements during the life-cycle of a repo while simultaneously taking advantage of the EUR1.15 trillion of outstanding investment funds held in Euroclear France.
Post-Brexit and in line with the drive to promote the French marketplace, this initiative is both timely and appropriate.
This was a historic event as it was the first triparty repo transaction carried out on an electronic trading platform – previously only processed over the counter.
And, it was linked to the first lending transaction involving a HQLA investment fund in triparty repo.
Using HQLA funds as collateral and why it makes sense
New regulation and changing market conditions have led to a shortfall in the supply of traditional HQLA and an increased need for banks to hold and refinance new types of high quality asset classes – such as HQLA funds.
The advantage of holding a HQLA fund is that it allows the investor to invest in a diversified yet secured bond environment while entrusting his or her fund manager to generate a positive return.
Recent history demonstrates other tangible advantages.
For example, since early 2016, the EuroGovies Risk Balanced fund issued by Lyxor Asset Management has generated a return of +22bps, i.e. +51 bps on Eonia.
The same fund showed a controlled level of volatility – 50 to 60bps on a year-on-year basis compared to a rate ten times higher for the underlying bunds.
And, HQLA funds have the added bonus of complying with Basel III requirements in relation to the constitution of LCR (Liquidity Coverage Ratio) buffers.
Why is this new process attractive to the market?
Triparty repo has evolved into a key way of monetising assets (2), allowing firms to temporarily exchange securities against cash (or other securities).
In the case of a fund, it replaces the need for the issuer of the fund to redeem assets.
This benefits both parties as it prevents a capital loss for the asset holder and protects the stability of the fund for the issuer.
But there are also other benefits.
First of all, outsourcing the collateral management to a proven triparty agent with the scale of Euroclear ensures sound collateral allocation and valuation procedures, while offering a wide range of optimisation options.
It is worth noting that the monetisation process of a triparty fund is identical to the monetisation process of the directly held underlying assets.
Effectively holders can therefore tap into a new source of liquidity without any additional risk or complexity.
Secondly, the use of a trading platform simplifies access to the collateral market – and demystifies its complexity – while offering more liquidity, transparency and useful relevant information (such as market data, legal contracts, credit items).
On top of these existing benefits, Elixium intends to diversify its participant base during the course of 2017 to meet the requirements of banks and their buyside clients by gradually integrating asset managers, insurance companies, clearing house cash positions and non-financial undertaking cash positions, which represents a major competitive advantage in a still fragmented world.
The bigger picture
The monetisation of investments funds via triparty repo is likely to become increasingly important at European level, particularly in stressed market conditions where obtaining liquidity from traditional HQLA can be challenging.
But, the use of HQLA funds as collateral in triparty repo is just the first step.
Eligibility of this asset class with CCPs and eventually with the ECB for refinancing is the ultimate goal.
The potential size of this new segment means that the market is already looking to the regulators to provide clarity.
In particular there is a need for a clear definition of what exactly a HQLA fund is and its underlying assets.
Additionally, standardised criteria will need to be developed in order to determine whether a fund meets the required levels of liquidity in order to make it eligible as collateral for triparty repo.
Irrespective of the initial teething problems, any initiative that helps the market broaden the assets with which it can access previously untapped liquidity pools is a welcome one.
So it is likely that the use of HQLA funds in the securities financing business will continue to increase as we move through 2017.
(1) High Quality Liquid Asset: Highly liquid assets with top rating levels
(2) Monetisation: the process of exchanging assets against cash, by way of sale, or through a reverse transaction (bilateral repo or triparty repo)