As well as contributing substantially to the scarcity of fixed income collateral, regulatory change has also played its part in changing attitudes toward use of equity as collateral. For example, the Basel Committee on Banking Supervision acceded to sell-side requests for blue-chip index constituents to be included in the definition of HQLA under Basel III’s Liquidity Coverage Ratio (LCR).
Similarly, the collateral guidelines for margin payments for non-cleared OTC derivatives – as set by IOSCO-CPMI – also explicitly include equities. Although movement has been slower in areas where practice has already been well established, there have been widespread industry discussions on the use of equities for collateral at clearing houses and in central bank settlement operations.
Even in such a conducive climate, progress can be gradual, and not necessarily linear. Indeed, there are still several reasons for market participants to cleave to the tried-and-tested forms of collateral, despite previously-noted restrictions on supply, at least in the short term. These include regulatory inconsistency on equity eligibility, the need to develop the necessary risk management expertise and tools on enterprise-wide collateral desks, and regulatory limitations on use of lower grade equities. Supply of equity collateral might even be a concern due to the risk management obligations being imposed UCITS and other mutual funds.
According to a leading agency lender, there has been 'tremendous' growth in demand among borrowers to pledge equity as collateral, versus cash or fixed income instruments, but also acknowledges the challenges this presents.
At the time of writing, Citi agency lending business estimated there was a 50:50 split between cash and fixed income five years ago, in terms of collateral pledged to facilitate transactions between borrowers and lenders. More recently, equities has accounted for around 30% of collateral. Evidently, one of the main drivers was stock borrowers’ growing willingness to pledge equities (regardless of what they’re borrowing) and the ‘upgrade trade’, i.e. banks and other market participants that pledge equities in order to borrow cash and high-grade fixed income instruments, often for regulatory reasons.
First, pledging equities when borrowing equities can lead to a strong risk correlation, which may need to be offset via access to a diverse range debt and equity collateral. Second, participants in the upgrade trade could fall foul of wrong-way risk in times of market stress, whereby equity prices go up and the value of bonds goes down, calling margins and haircuts into play.
Furthermore, the impact of regulatory change on collateral preferences can be both temporary and unpredictable. Although TPA data shows that banks increased the proportion of equites used as collateral as their balance sheets have expanded – rising to 57% of all pledged non-cash collateral in June 2015 – constrained balance sheets subsequently led banks to hold fewer high-RWA equities on balance sheets, resulting in a drop to 41% in early 2016.