A recent industry article in risk magazine suggested that the buy side hopes to retreat to the usage of “dirty CSA” as we face a collateral crunch.
In addition, we have seen the CME extend its collateral eligibility criteria to include short-term UST ETFs (exchange-traded funds) for Initial Margin purposes.
Why? What is going on?
Globally, interest rates are rising fast, and inflation is as high as I can remember. The geopolitical environment continues to be a topic at dinner tables around the world with tensions (wars) seemingly no closer to resolution as we go to press (some will never go away!)
All the above leads to market volatility in some way, shape or form. With market volatility comes collateral movements, which generally means an increase in collateral for market participants. Whether this is for cleared or bilateral portfolios no longer matters. As we know, requirements for variation and initial margin are integral to both.
Specific industry participants have different needs when considering the volume and types of collateral they require.
Let us consider a buy-side pension fund as an example.
The pension fund industry has long had issues posting cash collateral for variation margin (VM), which is one of the key reasons they have not been required to clear their OTC derivatives portfolios. N.B. Expiry is due in 2023. Check out our previous article on PSA Clearing.
A pension fund has little interest in holding cash as a particular strategy. Still, it historically has needed cash to satisfy margin calls, especially under uncleared margin rules where this tends to be the norm. That said, we have seen an increased demand for bond collateral to satisfy the VM obligations on legacy portfolios and are starting to hear about increased requirements for bond collateral usage on VM positions under uncleared margin rules (UMR) or regulatory portfolios.
For the dealer, receiving non-cash collateral comes at a cost; unlike cash, there is no offset against the leverage ratio for bonds, which means a passing over of costs (trade pricing) to the client as funding, capital and liquidity requirements are built into the trade via the XVA desk.
For pension funds that are inclined, accessing the repo market could be critical to enable managers to access cash to satisfy margin calls and provide themselves with optionality on pricing (multiple CSAs) at the point of trade. This isn’t always available in times of market stress if forays into the repo market are few and far between.
On the sell-side, all liquidity providers should have some form of collateral optimisation. For clearing members, this is magnified as they have a requirement to meet multiple margin calls across venues and geographies, potentially for numerous clients.
The members should be looking to optimise collateral as best they can in line with the pricing of the derivative and on a cheapest-to-deliver basis. As Initial Margin requirements increase and Brexit change brings reduced opportunity for offset due to bifurcation, it is clear that collateral access remains highly important for all.
In just two scenarios, you can see that there are interconnections between the derivative and repo/securities lending markets which we expect to increase.
It’s been a long-time ambition of the dealers to work down the credit scale (corporate bonds) and across types of collateral (Equity, MMFs). As we enter the final days of phase six for UMR, it may be that the buy-side is keen to explore further how that might positively impact them and their day-to-day portfolio cost management for collateral and margin.
If you would like to discuss any aspect of this, please drop me a line at email@example.com or call me on 07458 300 920.