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Collateral: Issues & Challenges for the Cleared World

In the light of the changes to collateral and segregation practices and to help clarify the changing relationships and extra options open to market participants Contango Operations’ Richard Wilkinson explores the key topics covered by the term “Cleared Collateral “. For ease of reference the old (pre-crisis) environment is referred to as “BC” and the new (post-crisis) environment as “PC”.

Segregation

BC - GCMs/FCMs offered a simple choice of segregated or non-segregated collateral. The former offered protection against the default of the clearing firm, but NOT defaults of other clients that could wipe out the collateral pool. The latter protected clients from the default of other clients, but left the client exposed to the potential default of the clearer itself

PC - The key to portability is being able to identify what belongs to whom at any point & be able to move it quickly and efficiently. Much has been talked about the CCPs role in this, but the FCMs still have a major part to play, as it is they who have to be able to perform the same identification & reconciliation as they are the principle to the underlying client. Whilst the FCMs already perform reconciliations of collateral vis-a-vis their clients, the added complexity arises from ensuring the client collateral is ring-fenced (either logically or physically) from both the FCMs own collateral and that of other clients.

Collateral Transformation

This function is simply the “upgrade trade” turning non-eligible collateral into eligible collateral. This is possibly the new alchemy and, if the industry isn’t very careful, the source of the next crisis. People have spoken about collateral squeezes as one of the unintended consequences of the new regulatory environment, but there are more fundamental issues that need to be addressed: how is the collateral transformed from an ownership perspective? Under what type of agreement is the collateral transformed? What level of re-hypothecation is applied (and is this available under a pledge type agreement)?

BC - This was simply referred to as margin or collateral financing. Ineligible collateral was taken in by the clearer and either held on account or lent out in order to generate cash or eligible collateral, which was then posted to the CCP.

PC - As mentioned in the introduction, a whole new industry is developing which, if not monitored closely could be the source of the next crisis. There are many questions that need discussion and agreement on the process of swapping collateral.

Title Transfer vs. Pledge

Title Transfer gives the receiving party absolute control over the collateral, whilst pledge allows the provider to retain certain rights: most notable is that under pledge, collateral sits outside the estate of a bankrupt collateral taker.

BC - Clients would opt to either allow or disallow collateral to be re-used by their FCM. Generally, “pledge” disallowed the re-use of collateral by the FCM, EXCEPT where it was posted to the CCP in order to cover the clients’ margin requirements. Title Transfer enabled the FCM to use the collateral for its’ own purposes.

PC - Using collateral transformation could create conflicts if the client-FCM relationship is different from the FCM-CCP. Further, we need to drill down on how transformed collateral should be treated in the event of a client/FCM default and whether the industry needs to have two sets of rules in place to manage pure vs. swapped collateral.

Value vs. Asset Protection

The buy-side does not understand why collateral is not covered under an asset protection regime. We do not want to get back to the bad old days of registered securities and non-fungible CSD accounts, but we do need to get answers from the CCPs/FCMs about why they cannot impose asset protection on collateral they receive.

To discuss this article in further detail, please contact:

RICHARD WILKINSON Senior Associate Contango Markets Ltd www.contango.co.uk Tel: +44 (0) 7912 693258 richard@contango.co.uk