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New OTC derivatives world could see collateral squeeze, say industry experts

, May 3, 2012, 0 Comments

Over-the-counter (OTC) derivatives structurers operating in the new Dodd-Frank and European Market Infrastructure Regulation (EMIR) world will need to shell out more collateral in the form of cash and high-quality assets to prevent systemic risks, industry experts said. A greater risk is the danger of a collateral squeeze caused by a reduction in high-quality assets and compounded by a surge in demand for such assets, said Kishore Ramakrishnan, senior manager, financial services advisory at Ernst & Young in Hong Kong.

The recently published International Monetary Fund (IMF) Global Financial Stability Report highlighted a grim scenario in the new OTC derivatives world, following sweeping global regulatory reforms. Specifically, it pointed out two main factors that might contribute to a surge in demand for collateral: the widespread adoption of central counterparty clearing (CCP) and Basel III’s liquidity coverage ratio (LCR). The IMF estimated that more than 80 percent of OTC derivatives transactions would need to depend on the use of collateral. This estimate was based on a 2010 finding which showed that 80 percent of collateral that backed up the global OTC derivatives trades was in cash, with around 17 percent of that collateral being government securities.

Views & Opinion by

Kishore Ramakrishnan

Senior Manager, E&Y-Hong Kong

Liquidity could dry up
Ramakrishnan said that posting high-quality assets such as government bonds or anything as liquid as cash could potentially lead to liquidity drying up. He cited the results of the International Swaps and Derivatives Association (ISDA) 2011 Margin survey which showed that around 80 percent of all OTC derivatives trades executed by the world’s 14 largest dealers were subjected to collateral agreements. Cash used as collateral represented 80 percent of collateral delivered in 2010, while government securities such as U.S. Treasuries, UK gilts, Japan government bonds (JGBs) constituted 10 percent of collateral received and 17 percent of the collateral delivered, according to the survey.

“This means that there will be a huge demand for high- and good-quality assets to the dealers, and yet on the other hand the quality of liquid assets has reduced because a lot of the sovereigns are now in crisis. So the problem is compounded by the demand which will surge and that has resulted in what we called a collateral squeeze”.

Collateral coming out of the dark
Collateral management, according to Ramakrishnan, has traditionally been viewed as a cost centre and is generally not seen as generating revenue for banks. But the OTC derivatives industry has seen a transformation in the last four to five years for a number of reasons, he said. “The way the OTC derivatives business works now is that banks are now required to streamline their collateral management and it has come out of the shadow of a back office function and is being considered as a revenue-generating stream akin to front office trading desks. From that point, collateral management and collateral transformation services have taken the spotlight and it is now embedding itself into the starting point of OTC derivatives cycle instead of as an end point,” he said.

“But the global OTC derivatives regulations from Dodd-Frank Act to the European Market Infrastructure Regulation all the way to various local regulations in a number of jurisdictions in Asia, including Japan, South Korea, Singapore, Hong Kong and Australia, all pointed out the need for banks to streamline their collateral management in order to run their OTC derivatives business,” Ramakrishnan said.

Disclaimer:
Interview first appeared in “Thomson Reuters Compliance Complete Asia”
Copyright © & All rights reserved: Kishore Ramakrishnan,Ernst & Young |Thomson Reuters 2011.






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