Knowledge & Insight

Collateral in capital markets

Fri 21 April 2017

Since the financial crisis of 2007/2008, regulatory bodies and policymakers around the world have tightened their focus on the use of collateral in mitigating counterparty credit risk. As the true size and scope of such risks were highlighted during the “crash”, so the role of collateral has grown in importance, with sound backing becoming a standard requirement both for short- and long-term funding.

New margin requirements

This has heightened demand for collateral, and forthcoming regulatory changes to margin requirements for non-cleared derivatives look set to drive demand for high-quality assets even higher. Many banks and investment companies will have to balance competing priorities and comply with the Capital Requirements Regulation that stipulates liquid assets must be ring-fenced or placed under operational control of a separate division.

Optimising efficiency and ensuring compliance

The challenge for firms, therefore, will be to devise and manage highly efficient collateral management protocols, most probably via a central collateral management function (CCMF). The objective of the CCMF will be to achieve a holistic view of all the firm’s assets and liabilities, and to deliver total transparency, enabling firms to optimise efficiency and ensure continued regulatory compliance.

Efficient and prudent collateral management

Transparency will be key, as regulators appear set to demand greater disclosure of information around the use of collateral, where it is held, and how collateral if re-hypothecated. And although the new regulations will undoubtedly place new demands on firms, in the long-term, they will encourage efficient and prudent collateral management, and hopefully help to mitigate and drive out the kind of risk that can destabilise markets globally.

A key driver of competitive advantage

The overall effect of these changes will be to increase demand for sound assets. And as a recent paper by Deloitte points out, The Bank of England now estimates that demand for high-quality collateral stands at $1.6 trillion.

Of course, the value of collateral any firm uses to support its trading activities is driven by its business model, its mix of assets and its funding strategies. So a firm’s main lever for altering its collateral requirements is its collateral efficiency ratio. And achieving a leaner ratio means moving assets quickly and efficiently through the business. This requires a highly specialised skill-set, supported by the right systems and processes, which for smaller business, is likely to necessitate the outsourcing of their collateral management. While for larger firms, efficient collateral management will increasingly become a key driver of competitive advantage.

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