The evolution of collateral management within Asia
Asia continues to manage the range of reforms impacting existing collateral and collateral management legislation. Are we almost finished?
As insufficient collateralisation was cited as a one of the triggers of the substantial financial losses incurred during the crisis, Asian policymakers introduced new rules to increase market stability, enhance transparency and reduce counterparty and liquidity risk.
Notable examples included amendments to the Securities and Futures Ordinance (2014) in Hong Kong, the Securities and Futures Bill (2012) in Singapore and the Financial Instruments and Exchange Act in Japan.
As a result of these reforms, corresponding changes in Asian financial markets are impacting the management and evolution of the collateral management industry.
The growing complexity and cost of derivatives clearing, as well as the increased competition for high-quality collateral, pose significant challenges but also present opportunities for growth in the collateral management sector, especially with regards to efficiency and optimisation.
Collateral management – typically defined as the effective allocation of collateral to reduce risk – has been in a state of flux over the past few years.
For instance, the introduction of new rules that mandate central clearing for Over-The-Counter (OTC) derivatives and operational controls on non-cleared derivatives trades require clearing-houses to reduce or eliminate thresholds for variation margin.
Due to the greater level of regulatory intervention on liquidity requirements and the derivatives markets, there remains debate over the amount of collateral that will be needed to continue operational effectiveness in the post-crash global economy.
Estimates vary but a committee of the Bank for International Settlement (BIS) estimated that new liquidity requirements, combined with derivatives regulations, could take collateral obligations up to USD 4 trillion – equal to 40% of size of the Chinese economy.
Alternatively, an analysis by the International Swaps and Derivatives Association (ISDA), based upon regulators’ proposals, forecasted that collateral margin requirements could reach USD 10 trillion.
Collateral mobilisation under pressure
To compound this further, financial institutions continue to face difficulty when seeking to mobilise sufficient amounts of collateral to allocate against exposures.
Constraints on mobilisation are particularly pronounced in Asia, where the ability to transfer collateral across borders is increasingly undermined by market and regulatory fragmentation.
This is due to the fact that individual Asian countries often leverage their own local clearing-house – more so than their European and US counterparts – which weakens the collateral utilisation rate. Coupled with regulatory restrictions, these limitations have the potential to exacerbate market weaknesses during times of financial stress.
This is certainly the case in Asian markets as there are limited supplies of liquid sovereign debt (which is typically used as collateral) in the region’s financial centers such as Hong Kong and Singapore, particularly when compared with long-established markets in the US and Europe.
Change is coming
Whether used to conducting bilateral or triparty transactions, the Hong Kong, Singapore and Japanese financial centers continue to demonstrate increasing willingness to move away from single-line security transactions that can be easily converted into currency towards non-cash solutions.
On a banking level, investment portfolios are not simply comprised of large, 'established' global currencies such as the US Dollar, Sterling and Yen, yet often contain fast-growing domestic units such as the Philippine Peso and Malaysian Ringgit. As such, the move away from established bilateral trading is necessitating the growth of triparty agents.
As markets have continued to evolve, Asian governments and financial institutions are increasingly being forced to adopt regulatory reforms in order to keep up with the pace of change.
Many central banks have encouraged the use of repos and promoted the Basel Committee on Banking Supervision (BCBS) and International Organisation of Securities Commissions (IOSCO) guidelines for collateralising margins on OTC derivatives trades to ensure transactions are effectively managed throughout their tenure and variation margin calculations are processed as efficiently as possible.
Pension funds have similarly utilised the market, using derivatives to manage against market volatility and collateral against counterparty risk.
Financial institutions, however, are still adjusting to the consequences of collateral regulations. The challenge for collateral management participants is to simultaneously implement international ‘best practices’ and leverage infrastructure providers to fill any unintended gaps, whilst ensuring these processes do not produce regional silos or result in exclusion of their domestic securities from international markets.
Collateral is still central to business activities
Despite concerns about the liquidity squeeze created in Asia due to increased collateral demands, the situation is stable. In fact, Hong Kong is pursuing plans for a new Regional Treasury Centre to enhance its attractiveness to Chinese and global investors and the formerly insular Japan engaging with Singapore and Hong Kong to reinforce cooperation.
However, as there is a considerable degree of uncertainty surrounding the codification of collateral regulations by separate Asian jurisdictions – particularly with regards to the BCBS and IOSCO recommendations – it remains unclear as to what precisely the impacts, both negative and positive, will be on the collateral management industry in Asia. Further to this, with Asian markets at different stages of compliance, there is a corresponding uncertainty about the speed of full implementation for each market in the region.
Nevertheless, the Asian markets are showing an increasing willingness to comply with varying parts of these regulations, especially if they are to continue trading collateral and derivatives in the US and European markets.
With large amounts of collateral expected to be exchanged in the Asian region, the requirement of clearing houses to reform clearing processes and accept securities as collateral will only grow in importance and necessity.
The future remains bright
Despite the challenges posed by market fragmentation and a lack of a united model of financial regulatory oversight such as that provided by the European Union, significant opportunities exist for the expansion of the collateral management sector across Asia.
Hong Kong, Singapore and Japan, each of whom possess advanced economies with attractive business climates, strong investor protection and thrive on healthy inter-market competition, have all witnessed significant growth in the field of collateral management in recent years.
Singapore and Hong Kong, who have long fought one another for the mantle of 'gateway to Asia', share a number of similarities in respect of openness yet differ in respect of their core activities. Singapore has long been positioned as major regional commodity hub and wealth management centre, while Hong Kong leads the market for IPO and international investment banking activity.
In the case of Japan, the country's financial services sector is more domestic-oriented with understanding of collateral management remaining rather muted given the limited focus local institutions place upon providing triparty services.
Like Hong Kong and Singapore, however, acute awareness exists of the need to expand cross-border financial services activities in order to sustain growth; the country's Prime Minister Shinzo Abe having led more than 80 foreign delegations to make the case for Japan as a trading and investment hub since 2012.
Risk versus reward
The collateral management sector looks set to confront established commercial practices within the financial services sector, challenge governments and regulators and strengthen market competition for consumers.
As with all changes, the growth in the collateral management sector poses risks – yet the opportunities for commercial reward are legion.