When Lehman Brothers faced collapse, pressing margin calls and the lack of liquidity exposed the interdependencies and weaknesses of the financial markets and sparked the Global Financial Crisis (GFC).
As a result, regulators focused on mechanisms to detect the build-up of concentrated risk, increased capital adequacy and liquid asset ratios for banks and long-term assurance companies, central clearing of Over the Counter (OTC) transactions through Central Counterparties (CCP), asset safety and the collateralisation of financial transactions that are not centrally cleared.
With the demand for collateral expected to increase with the plethora of new regulations, pressure will be placed on the use of cash as collateral or margin, leading to a greater use of illegible high-quality securities as banks endeavour to retain liquid assets on their balance sheets for regulatory requirements.
Can local banks and affected parties, such as pension funds and hedge funds, afford the risk of not adopting collateral management and collateral optimisation mechanisms?
Strate recently held a Collateral Management Seminar in November, with speakers from The Hedge Fund Academy, MD Attorneys, Absa Capital, Deloitte Consulting and Strate Ltd to review the impact on collateral of changing regulation and discuss the need for collateral management systems and collateral optimisation from a South African perspective.
Increasing demand for collateral
The increasing demand has been well publicised, underpinned primarily by the adoption of Basel III, which aims to strengthen the banks’ capital reserves through holding greater amounts of liquid assets or high-quality eligible collateral against financial exposures. In addition, Regulation 28 of the Pension Funds Act and Solvency II for life companies will also bring a greater requirement for the use of collateral.
Marilyn Ramplin of the Hedge Fund Academy highlighted that when the GFC hit, not all banks could determine their exposures to possible defaulting parties. She said that when Lehman Brothers collapsed, banks tried to work out if they had enough collateral themselves and if they were collateralising the right counterparties.
Collateral management must have a legal framework to underpin the structures in place in order to make sure the collateral framework that has been built has a very strong foundation. The most important lesson is that you can have the most sophisticated collateral management process, but if you don’t have the right legal framework, the whole thing falls apart … and some companies learnt that the hard way,” added Ramplin.
Since the crisis, the Group of Twenty Finance Ministers and Central Bank Governors (G-20), which includes South Africa, have set requirements to ensure the mitigation of any further risks associated with the areas that contributed to the actual crisis. Many of these G-20 requirements specifically focus on over-the-counter (OTC) derivatives and the lack of high quality collateral against these financial exposures as a key contributor to the crisis.
As such, all OTC derivative contracts will need to be centrally cleared through CCPs and reported to a Trade Repository. For those OTC derivatives not centrally cleared, the OTC counterparty will be required to hold additional capital against those positions, making it more expensive to trade OTC derivatives. Relief will be granted where eligible high quality collateral is in place against these exposures.
OTC derivatives play a very important part in the market because they help hedge risk. If one now has the additional cost of a higher capital charge on OTC derivatives, we need to think about what the impact will be on the market and how we mitigate risks associated with this,” added Ramplin.
Michael Denenga of MD Attorneys maintained that international developments coming to the fore are also expected to change the landscape locally in South Africa. “There are rules and recommendations from the International Institute for the Unification of Private and International Law (Unidroit) aimed at improving laws around securities holding, transfer and collateralisation.” Denenga added that collateral is an important aspect of the Financial Markets Bill as the Bill enables central counterparty clearing, reporting to a trade repository and segregated depository accounts, to name a few.
According to Ashley Sadie of Deloitte Consulting, the use of collateral has skyrocketed from a value of US$437bn in 2001 to US$ 3.6trn over the last ten years, as lenders called for a ‘promise’ that they would have some form of asset that could be taken if the borrower had to default against its liability.
With cash predominantly used as collateral in South Africa, the new Basel III rules could make banks want to hold more cash, making them unwilling to lend. Sadie says:
Already, Basel II requires greater amounts of high-quality liquid assets. However, there is a shortfall of these assets among South African banks. The South African Reserve Bank has indicated that there will be an estimated R900bn liquidity gap should the banks adopt Basel III in their current operations.”
As a result, a shortage of high-quality collateral in the market is likely as industry pressures are expected to create a liquidity squeeze if not properly managed.
Solutions to save cash
To comply with these changes, local banks may find it beneficial to substitute cash used as collateral with other assets and streamline their operations to find effective ways to conserve cash, according to Absa Capital’s Jan Kotze.
Globally, there is a move to use securities as collateral. An estimated R7 billion of listed equities are sitting on the books of South African banks, according to Deloitte, which could be used as collateral to free up cash. “Equities can be viewed as part of an holistic approach to try and meet the new Basel III requirements. Equities, if managed correctly, could be a good alternative to cash for collateral,” said Sadie.
Strate’s Chief Operating Officer, Anthony van Eden, added that the management of eligible collateral in terms of the bilateral eligibility criteria can be administratively intensive and often leads to a lack of visibility of the size and location of collateral placed and the inefficient use of collateral. The build-up of collateral silos across financial products and geographic locations also leads to inefficient use of collateral or often over-collateralisation. Studies show that in 2007, global defaults on debt were US$8 billion, which spiked to over US$400 billion a year later – when the financial crisis hit.
There is a growing demand for more automated collateral management solutions, focusing on systems that streamline processes and improve operational efficiencies through enhanced straight through processes. The focus and trend internationally is to adopt a single-, centralised market-wide collateral management system that manages the members’ pool of exposures against the members’ pool of collateral placed,” adds van Eden.
The South African financial market is looking at a centralised, market-wide, multi-asset class integrated collateral management solution to complement current collateral management functions within financial institutions.
This is aimed at improving the tracking and efficient use of collateral management in South Africa with a service that will be offered by the country’s licenced Central Securities Depository, Strate.
It will be an effective automated collateral solution on a marketwide ‘pooled’ basis, with the opportunity to optimise the total collateral requirements of the members to the service against financial exposures without the requirement to place any additional collateral, which may have been the case on a pure bilateral arrangement with counterparties. This optimisation is achieved through a series of collateral substitutions among the multitude of counterparty bilateral relationships in the ‘pool’. This concept reduces the requirement for cash margin calls that are normally encountered on bilateral relationships when there is an insufficiency of eligible securities. Only the member that placed collateral in the pool can call for its return.
Pooling of available collateral to meet the pooled exposures of members is important because securities that are available to be given and received as collateral are visible and can immediately be substituted when required. Regular intraday automated collateral valuation ensures that any collateral paced that is no longer required will automatically be returned to the rightful owner. Strate’s Tri-Party Collateral Management service is designed for those institutions without any form of collateral management as well as to compliment current collateral management functions and systems that may exist within institutions. The service is aimed at cost reduction and efficiencies by using existing systems and processes, while complying with the region’s regulations to manage eligible dematerialised bonds, equities and money markets in multi-currencies.
It is expected to launch in November 2013.
For more information, please contact Steve Everett on 011 759 5496 or SteveE@strate.co.za.