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

The fact that collateral has become so much sought-after is a new phenomenon, and one which has come about largely because of the global OTC derivatives regulatory reforms, in particular the need for OTC derivatives trades to be cleared through CCPs required by the new OTC derivatives regulations, as well as the new Basel III capital and liquidity requirements.
“The shift to a CCP regime will elevate the collateral demand by between $100 billion to $200 billion for initial margin and guarantee funds, thereby directly reducing the ability to rehypothecate or re-use the collateral. This in turn would intensify the [need for] financial institutions to scout for alternate ‘collateral’ assets to meet the desired aggregate funding volumes,” Ramakrishnan said.

Impact of Basel III on OTC derivatives business
He said the impact of Basel III on the OTC derivatives business could not be underestimated as it adds strain to high-quality assets. “Basel III requires at least 60 percent of banks’ tier-one capital to be in the form of cash and government bonds, and up to 40 percent of their tier-two assets would need to be highest rated corporate bonds in order to meet the LCR requirements. Furthermore the quality of high-quality assets is reducing because many countries are now in sovereign crisis. The question then to ask is: what if the proportion of tier-2 assets are increased to meet a critical component of LCR requirement? Say if the LCR is increased to 45 percent, you can imagine how much it will be a squeeze on assets to the banks. It would also be interesting to see if the definition of tier-2 assets will be broaden to include a broad range of corporate bonds and perhaps equity assets. OTC derivatives regulations such as the Dodd-Frank Act, EMIR and other Asian regulations have all spiked the demand for collateral assets,” Ramakrishnan said.

Although the new OTC derivatives regulations have given rise to what is known as clearable standardised OTC derivatives trades, non-cleared bilateral trades, according to Ramakrishnan, would still be subjected to huge capital and margin requirements. “Non-cleared bilateral OTC derivatives trades would still be subjected to capital and margin requirements as appropriate weightages would have to be assigned to such OTC transactions as prescribed under the Basel III regime. For standardised trades that will be cleared through CCPs, they will be subjected to variation margins,” he added.

With the implementation of mandatory clearing of OTC derivatives — originally scheduled for January 2012 — taking longer to achieve, Peter Connor, head of markets clearing Asia Pacific at Deutsche Bank Global Markets in Sydney, said the market has focused on Basel III and its requirements for banks to hold a lot more capital against OTC derivatives trades. The impending Basel III framework, he added, would instead create the economic incentives for transactions to be centrally cleared.

“Basel III introduces a Credit Value Adjustment (CVA) and in some instances this will require banks to hold substantially more capital against bilateral OTC derivatives trades. Banks now have to assign capital against the assets created by client’s mark-to-market losses in their derivatives portfolio. The cost of this additional capital will be reflected in the price of the transaction, and therefore it will be passed on to counterparties unless the transaction can be centrally cleared and the CVA charges avoided”.

Economics will drive business
Connor said because of the additional capital requirements, the economics of doing OTC derivatives trades would eventually drive the business, which he added would be of particular concern to the second and third tier market players. “Now clients have to make sure that they have the clearing capacity, including having the provider, the legal operations set out as well as having clearing and collateral in place. All this will take a minimum of three months depending on whether they have the systems and software,” he said.

Connor said with the additional capital requirements under Basel III coming into force in 2013, the economics of executing bilateral OTC derivatives trades could begin to drive greater volumes into CCPs. He pointed out that the major dealers would join the CCPs directly, but many of the second and third tier market players would need access to the CCPs via a client clearing arrangement.

“Many of our clients are working hard to make sure that they have the capability to clear OTC derivatives transactions. This requires input from the risk and operational functions within an organisation. Furthermore, if clearing into a CCP means clients have to post collateral against their OTC derivatives portfolio for the first time, this could have significant impact on the organisation. This is because they would need to ensure the they have sufficient eligible securities and cash available,” he explained.

Ramakrishnan agreed and pointed out that the second and third tier players in the OTC derivatives market such as asset management companies and the corporate sector, which lack deep pockets unlike the top 10 dealers such as JP Morgan, Goldman Sachs, and UBS, are beginning to question if it would be worthwhile for them to be in the OTC derivatives business as a means to hedge their risk such as interest rate risk and credit risk exposures. This is because clearing through a CCP requires huge amount of capital up front which will go into registering as a clearing member, as well as paying for initial and variation margins, and default funds to the CCP. “They are now thinking of using alternative financial products which will reduce their regulatory burden and yet efficient and able to hedge their credit risk and interest rates swaps risk, and also less stringent when it comes to collateral management, with lower capital requirements,” he said.

Ramakrishnan said official statistics had shown that of the $700 trillion of notional outstanding OTC derivatives business, about 90 percent of them were covered by the top 10 dealers, with the remainder being handled by second or third-tier players.

New revenue stream for top dealers; new financial innovations
Industry players said, however, that not all was doom and gloom in the new OTC derivatives world. For the top dealers at least, client clearing would be a new revenue stream as second and third tier players which lack the capital to clear their trades through CCPs would look to the top dealers to clear their trades. Connor said institutions with strong credit ratings, global reach to CCPs across many markets, and a strong risk management culture are best placed to provide client clearing services.

Ramakrishnan, on the other hand, believed that the new regulations would see an emergence of new financial innovations, such as exchange-traded funds, which could help OTC derivatives players hedge their credit and interest rate risks.