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How bad any race to the bottom becomes, if it even becomes a reality at all, depends on how big the collateral shortfall is. While the exact number is an unknown, with estimates widely ranging from around $500 billion to $8 trillion, there is, by and large, a consensus that there will be a collateral shortfall; that there exists insufficient quality collateral to satisfy the post-crises regulatory environment.
CCPs will be taking initial and variation margin to offset the risk of a potential default in a trade, acting as the do as a buyer to every seller and a seller to every buyer. If one party cannot make good on its position, the CCP will step in and complete the transaction, utilizing that clearing participant’s margin and default fund to do so. If market participants cannot obtain eligible criteria to post as margin in order to clear, then what can they do? Clearing will soon be unavoidable.
CCPs are competitive entities and there is a possibility – a fear, even – that they will lower their collateral standards in order to facilitate client clearing, helping them to win new business. Market participants have a number of collateral demands placed on them currently, and knowing where their assets are and what they can be used for is crucial from a competitive view point. If assets are ineligible, then market participants can undergo a collateral transformation process – changing ineligible collateral into eligible collateral.
“Something has to give,” says John van Verre, global head of custody at HSBC Securities Services. “Collateral management is one of the biggest challenges facing our clients,” continues van Verre. “They need to know where their assets are and how they can be utilized. With central clearing they must appoint a clearing broker who accesses a CCP – keeping track of assets is not a straightforward, two-way relationship. They must also work out how to most effectively use this collateral and if needs be, what they can most efficiently transform, bearing in mind that their assets are not just to be assigned to CCPs.”
The demands on collateral are, seemingly, ever increasing. Exchange-traded derivatives have been collateralized since time immemorial, but the shift to clearing and margining over the counter derivatives is where the bulk of the demand will now come from. Aside from cleared OTC transactions, there are also non-cleared OTC transactions that will need collateral posting against them as well. The non-cleared world will be a more expensive place than the cleared one, too.
While there are options available to market participants in regards of collateral transformation and compression, the most cost efficient way of posting collateral is to post what you have available at that time. As CCPs compete, it will be very tempting for them to start accepting lower-quality, more illiquid collateral – especially if the high-quality government debt is inaccessible.
If a CCP finds itself in a position where it has to liquidate a clearing participant’s collateral in order to make good a trade, then it will need highly liquid collateral in order to do so – government bonds fall under this category for countries such as the US and the UK. Until such a time of market stress, the requisite liquidity of the collateral remains unknown. We will not know how great the collateral shortfall is, or how far the race to the bottom has been run, until clearing participants start to default.