Download Illuminating Markets - a vision for cash and collateral

Illuminating Markets - a vision for cash
and collateral management
Changes to the regulatory environment that have already taken place, and those that will
occur over the next few years, have put us on a path that will change the industry forever.
The impact on how the industry executes its business has been fundamentally changed.
The impact of these changes has been an almost uniform decline in profitability for Investment banks. Many
operations have already begun efforts to re-structure large areas of their business to maintain return on
equity (ROE) levels that are acceptable to their shareholders. This process will continue for several years yet.
I suggest reading ICMA’s excellent report written by Andy Hill “Perspectives from the eye of the storm” for
more information about the current and future evolution of the repo market.
Basel III significantly increases the cost of doing business, taking risk and market-making via increased
capital requirements and increasing the cost to certain activities by requiring higher quality and amounts of
capital. (See leverage ratio and liquidity coverage/net stable funding ratio -Basel III1). The more balance
sheet intensive a particular business area is, the higher the “hurdle rate” for returns should be. In this regard
Bond trading and market making/repo stand out.
Many firms have not yet implemented an exhaustive study of what these hurdle rates ought to be. These are
not standard across the industry but are firm specific and are calculated using varying inputs particular to
each individual institution and their relevant regulatory requirements. Ultimately these metrics will decide
what each institution’s balance sheet will be and the required ROE.
We believe that as this process of re-pricing and charging business areas for the regulatory cost of partaking
in certain businesses (and transactions) progresses, the market will find many more institutions cutting back
and re-structuring their current business models, or simply pulling out of certain markets or product lines
altogether.
NSFR (Net Stable Funding Requirement) rules under Basel III are calibrated such that longer-term liabilities
are assumed to be more stable than short term liabilities. As such we believe that this will lead to greater
demand for longer dated deposits, particularly corporate deposits which are treated favourably for banks
under the rules.
Basel III is the global framework of principals that are agreed internationally which local regulators are consequently expected to implement into
local law. It is worth noting that the US and EU are not 100%aligned on leverage ratio. (See CRD IV for the EU rules)
1
NSFR provides for different, Available Stable Funding (ASF) and Required Stable Funding (RSF), weightings
depending on the type of counterparty and the residual maturity of the transaction. This will make many
financing transactions that are still viable under current regulatory capital treatment extremely onerous. Fifty
percent RSF weightings will be applied to all loans (including reverse-repos) to non-banks, regardless of the
residual maturity of the transaction, and independent of the underlying asset. In other words, this would
mean that all reverse-repos with non-banks under one-year maturity would require the provision of stable
funding against 50% of the value of the reverse-repo. For example, a bank transacting a $100 million
overnight reverse in AAA government bonds with an insurance company or hedge fund would carry a
requirement for $50 million of (long term) stable funding, even if this reverse was match-funded by repo.
The FRTB (Fundamental Review of the Trading Book) due to be implemented in local regulation by 2019, is
a supervisory framework for the next generation of market risk regulatory capital rules for international banks.
It will add further granularity to this process by identifying how profitable each business is within an institution
at a “desk Level”.
It will also overhaul the standardised approach to market risk, forcing big banks to calculate and report it for
the first time, radically altering the way that modelling approval is granted and policed, Value-at-risk (VAR)
will be replaced with expected shortfall (ES) as the standard risk measure, redefining the boundary between
banking and trading books. Approval by the regulator will be required, at a desk level, for banks to operate
using their own internal models.
An ISDA study of 21 sample Banks concluded that, as a result of FRTB implementation, the overall increase
in market risk capital, would be between 1.5x and 2.4x compared to current levels.
Current implication for repo
The cost of providing balance sheet to customers that may simply require a home for their cash has become
increasingly prohibitive, leaving some banks having to turn away short term deposits/repo’s and/or charge
what might look like unreasonable costs for either accepting said deposits or only offering the facility to
clients from whom they generate revenue on other products as part of a wider relationship.
Because of this lack of willingness to, or difficulty in, pricing collateral transactions, many of these
transactions have become economically unviable. Backward-dated pricing and resulting dysfunctional
collateral markets are in evidence not only during reporting periods such as month, quarter, half and year
end, but increasingly over a “normal” date run – volumes and liquidity are both showing signs of drying up.
“Previously, business lines might have been kept as part of the core business strategy, even if they did not
meet the hurdle rate for returns .But in time banks will become more ruthless and cost aware about whether
these activities can be a valid part of a long-term business model “
“Repo, as a standalone product, is no longer profitable. Repo desks have gone from being profit centres to
cost centres. This has already happened; whether yet realised or not” – Andy Hill -ICMA.
“The provision of repo pricing and liquidity by banks has become more of a value-added service for clients,
largely subsidised by other, more profitable businesses. “ ICMA quarterly report Q4 2015 – pages 25-28.
Improving efficiency
There has been an exodus of banks from non-core businesses, but even in areas where they remain active,
banks can make significant cost savings by accessing liquidity pool providers (such as Elixium) for
distribution .This leads on to the next area of regulation which needs to be addressed.
Harmonisation of settlement
Basel rules are implemented as the Capital Requirements Directive in Europe and the specific capital
requirements for EU firms are based on their MiFID permissions.
There is increasing interest secured financing transactions, with the market moving from unsecured to
secured financing and impending enactment of regulation surrounding the margining of OTC products. There
is a stream of regulation that will have a significant impact on collateralised markets which involves
harmonisation of settlement discipline regimes across Europe. The industry will have to identify an efficient
operating model to manage these changes.
ECB Harmonisation Progress Report 13/04/15 - page 46
Activity description
“The activity covers market practices or legislation that obligate or restrict the settlement of (stock exchange
and/or central counterparty-cleared) transactions in a specific issuer CSD. The consequence for foreign
investors, custodians and/or investor CSDs in such (issuer) markets is that access to settlement flows is
restricted owing to the unfair competitive advantages established in those issuer markets. The restriction
implies that entities wishing to offer settlement services on these securities need to become participants in
the issuer CSD or central counterparty.”
http://www.ecb.europa.eu/paym/t2s/progress/pdf/ag/fifth_harmonisation_progress_report_2015_04.pdf?986629e4
68a824c5d0069151574ead5c
In an environment of litigation and lawsuits is it reasonable to suggest to pension funds, hedge funds,
sovereign wealth funds asset managers, CCPs, corporate treasurers, local authorities and other government
entities such as public utilities should be precluded from access to a transparent trading facility for the reinvestment of their short end cash and or securities or for sourcing collateral/margin ?
http://www.reuters.com/article/2015/11/26/interestrateswaps-lawsuit-idUSL1N13K2IE20151126
In Europe, EMIR sets out a legislative framework for Central Counterparties (CCPs), trade repositories and
OTC derivatives. This framework includes new requirements covering capital requirements, risk
managements and organisation.
MiFID2 will be introduced with a view to de-restricting market access on a non-discriminatory basis. There is
a requirement for Multilateral Trading Facilities to implement non-discriminatory rules regarding access to its
facility.
MiFID2 introduces additional pre and post-trade transparency requirements for a number of financial
instruments, these proposals aim to create a level playing field for the regulation of all organised trading.
The trading obligation in Europe will be introduced in the Markets in Financial Instruments Regulation
(MiFIR).
Mandatory Swaps Margining and the effect of Mandatory Swaps clearing
on collateral markets
Initial Margin (IM) and Variation Margin (VM) for uncleared OTC derivatives will be phased in from
September 2016 through to June 2021. The US will start IM from September 2016 for the largest of
counterparties but the EU has delayed the start of IM until June next year.
Clearing banks that traditionally put up money to support default funds within CCP’s are increasingly
reluctant to do so as they have to hold a significant amount of capital on their balance sheet to support
this business.
Variation margin to CCP’s must be in the form of cash – there is a need for collateral to cash transformation
and the size of the potential problem cannot be underestimated as banks step away from providing balance
sheet to support short dated, low margin repo activity.
CCP’s are working to engage buyside counterparties via differing initiatives be they sponsored or direct CCP
membership.
It is envisaged that mandatory swaps clearing in Europe could create unprecedented demand for high quality
liquid assets (HQLA) and its transformation, for use in initial and variation margining of swaps.
Eventually CCP’s may offer cross-netting capabilities across a range of products.
Elixium – re-engineering collateral markets.
Elixium is an all to all collateral trading platform that addresses the current fragmentary
nature of the market. Standardised processes and protocols facilitate a transparent,
efficient marketplace that simplifies the process of rapid counterparty diversification
amongst all institutions seeking to raise cash or collateral.
Connecting traditional players with new entrants and addressing the growing demand and supply of cash
and collateral presents an exciting opportunity for Elixium.
The repo and collateral market is a critical source of funding for many institutions but remains balance sheet
intensive. As institutions come under pressure as a result of regulatory changes such as the Liquidity
Coverage Ratio and Net Stable Funding Ratio, a reduction in balance sheets has impacted the depth and
cost of liquidity available.
It is broadly accepted that the market will see more buy-side entrants, and all-to-all trading. The Elixium all to
all marketplace has been developed specifically to facilitate access to a much wider counterparty base,
which previously, have been restricted from direct participation by overly complicated legal and restrictive
trading structures.
Legacy trading models are no longer as relevant in today’s market as they once were. As regulation creates
new challenges and reshapes the traditional repo market-making model, stakeholders are trying to adapt
and innovate both to meet those challenges and to exploit potential new opportunities.
Roberto Verrillo is head of strategy and markets at Elixium.
Example trade flow;
Regulation Timelines
Regulation
Effective Date
Regulation
Variation Margin requirement ( US ) will apply, on
new contracts ,where both qualifying counterparties
each have an aggregate month-end average
notional amount of non-cleared OTC derivatives for
March,April,May 2016 which exceeds Eur 3 trio . For all
other qual. c/p VM rule applies from March 2017
Sep 2016
Mandatory Initial Margin for uncleared OTC
derivatives starts - USA $ 4 trio plus trigger level
http://www.bis.org/publ/bcbs261.pdf
Nov 2016
Jan 2017
Mandatory IM for uncleared OTC derivatives starts EU. Aggregate month-end average notional amount
of non-centrally cleared OTC derivatives for March,
April, May 2016 exceeding Euro 3 trio
http://www.ifre.com/europe-fast-tracks-swapsmargin-rules/21266105.article
VM requirement for all EU counterparties. One major
variance bweteen the US & EU is that the CFTC is
proposing that only cash may be used for VM whereas
ESMA proposals allow a range of eligible collateral
from cash through to bonds, equities and gold
among others. http://www.globalcustodian.com/
Market-Infrastructure/Derivatives-rules-could-befast-tracked-by-EU/
Mar 2017
VM requirement ( US ) for any other covered swap
entity with respect to covered swaps with any other
counterparty
Aug 2017
EMIR 2yr extension on OTC clearing for certain
pension schemes expires. http://www.elexica.com/en/
legal-topics/asset-management/05-pension-fundclearing-exemption-extended-by-2-years
Mandatory IM for uncleared OTC derivatives - USA.
$ 3.0 trio plus trigger level
Sep 2017
Mandatory IM for uncleared OTC derivatives - EU.
Aggregate month-end average notional amount of
non-centrally cleared OTC derivatives for March, April,
May 2016 exceeding Euro 2.25 trio
NSFR is defined as the amount of available stable
funding (ASF) relative to the amount of required
stable funding (RSF). NSFR could increase the cost
of repo at a time when mandatory IM and VM result
in the need for a more liquid ( repo ) market.
http://www.nomura.com/primefinance/assets/
documents/nsfr.pdf
Jan 2018
MiFID II and MiFIR - Markets in Financial Instruments
Directive and Regulation. iDeals with Best execution,
Reporting of trades and Transparency of markets
- delayed from jan17. https://www.cliffordchance.
com/content/dam/cliffordchance/PDFDocuments/
MiFID_2_and_MiFIR_What_you_need_to_know.pdf
Aug 2018
EMIR further 1yr extension on OTC clearing for certain
pension schemes ends.
Mandatory IM for uncleared OTC derivatives - USA.
$ 2.0 trillion plus trigger level
Sep 2018
FRTB - Initial reporting begins.
http://www.bis.org/publ/bcbs265.pdf
Jan 2019
Mandatory IM for uncleared OTC derivatives - EU.
Aggregate month-end average notional amount of
non-centrally cleared OTC derivatives for March, April,
May 2016 exceeding Euro 1.5 trio.
Mandatory IM for uncleared OTC derivatives - USA.
$1.0 trio plus trigger level.
Sep 2019
FRTB - latest first reporting date
Dec 2019
Mandatory IM for uncleared OTC - EU. Aggregate
month-end average notional amount of non-centrally
cleared OTC derivatives for March, April, May 2016
exceeding Euro 8 bio - all others
Sep 2020
Variation Margin
Mandatory Initial Margin USA
MiFID II and MiFIR
NSFR
Mandatory IM for uncleared OTC derivatives - EU.
Aggregate month-end average notional amount of
non-centrally cleared OTC derivatives for March, April,
May 2016 exceeding Euro 0.75 trio
Mandatory IM for uncleared OTC derivatives - USA.
All Others.
Mandatory Initial Margin EU
EMIR
FRTB
This timeline is based on the best available information at the time of writing
Elixium Beaufort House 15 St Botolph Street London EC3A 7CN T 0207 198 5858
elixium.com