More people need it, there might not be enough of it, and much of it is locked up and cannot get to where it needs to go. Collateral is in demand and the hunt is on.

The Lehman meltdown and unravelling of unsecured contracts shocked politicians and regulators into doing something to make the financial system safer. Collateral was one of the solutions, and it is now in demand as derivatives contracts need to be collateralised and liquidity buffers need to be increased. However, this pursuit of collateral could inadvertently be creating more risk in the financial system, rather than actually reducing it. 

“I am not convinced that we have enough quality collateral where it needs to be in order to keep the capital markets functioning – not just as efficiently possible, but also safer than in the past,” says Thomas Zeeb, CEO of Six Securities, a Switzerland-based post-trade services provider. “This change in capital markets funding is the paradigm shift that we as an industry have to figure out.”

Perry Mehrling, a professor of economics at Columbia University’s Barnard College, frames the importance of collateral in the context of the rising role of shadow banking at the expense of traditional banking. “This is about trying to find the right institutions to make the brave new world of financial globalisation work,” he says. 

Regulation overdrive

After the G-20 leaders’ critical crisis-response meeting in 2009, a regulatory juggernaut was set in motion which means that over-the-counter (OTC) derivatives have to be cleared through a third party. These central counterparties (CCPs) sit in the middle of the transaction and take initial margin as collateral. Jonathan Philp, a treasury and capital markets expert at consultancy Everis, says of the new demands for collateral: “For buy-side and sell-side firms, initial margin is new for them. That is where the big step comes from.” 

The International Swaps and Derivatives Association (ISDA) estimates that there is currently about $40bn in initial margin posted at clearing houses for more than $300,000bn of cleared OTC derivatives. As well as posting margin for cleared contracts, there are also collateral requirements for uncleared contracts. The ISDA estimates that the proposals for uncleared margin would require at least $800bn for $127,000bn in OTC derivatives. And the amount of initial margin needed could even be as high as $10,200bn. 

“The scale of the need could be enormous,” says Stephen O’Connor, chairman at the ISDA. 

How much is needed? 

Amid all the regulatory change, no one is certain how much collateral is going to be needed. Rajen Shah, global head of collateral management at Citi, says that there are other estimates that $22,000bn of collateral could be required. He puts this in context of the total amount of US dollars and euros in cash, as well as the total amount of government debt, and says that there is enough supply for what is needed. However, he asks: “Is that collateral in the right hands? If it is not in the right hands, will the institutions holding it be willing to part with the assets considering the price versus the risk of parting with it? That is the trillion-dollar question.” 

Many observers agree that there is not an actual collateral shortage, but there is an issue of scarcity and of getting the collateral to where it needs to go. And there are fears that if the supply cannot reach the demand, there will be a crunch.

Soo Shin-Kobberstad, a senior analyst at Moody’s Investors Services, explains that a significant portion of the collateral that is needed to meet the initial margin requirements – highly liquid government securities and cash – is already locked up in central bank reserves. “The real risk of a collateral crunch is quite concrete, or imaginable,” she says. 

Aside from the collateral needed for derivatives, banks are also having to adjust to Basel III liquidity standards that require them to have a buffer of high-quality and liquid assets.

Policy problems

But it is not just regulation that is affecting the availability of collateral. Manmohan Singh, a senior economist at the International Monetary Fund (IMF), says that central bank policies are having more of an impact. For example, he estimates that since the Lehman crisis in September 2008, the US Federal Reserve has been housing about $2500bn of good collateral, and its quantitative easing is mopping up an additional $85bn a month. “Quantitative easing takes good collateral and puts it in a cupboard,” says Mr Singh. “It is being siloed – it does not move and it is not being reused.” 

Although regulation is affecting the demand for collateral – both for margin at CCPs and for liquidity coverage ratios – Mr Singh says that it is monetary policy that is affecting the availability of collateral right now. He argues that there is a timetable for regulatory change, which will be phased in over a few years. “Quantitative easing is already happening,” he says, adding that this is the reason why collateral is already siloed. 

Aside from central bank policies and regulatory demands, another factor that is affecting the movement of collateral is the connectivity of custodians.

Clearer solutions

Euroclear has developed the ‘Collateral Highway’ that has entry points of where the collateral is stored and exit points of where it needs to go. The network involves a whole system and chain of market participants and is open to CCPs, central securities depositaries (CSDs), central banks, and global and local custodians, as well as investment and commercial banks.

“We are working with custodians and CSDs to source collateral held in different silos to mobilise the collateral to where it is needed,” says Saheed Awan, global head of collateral management services at Euroclear. “The solution is completely automated and takes the collateral from where it is siloed and makes it freely available. The market needs a strong backbone of infrastructure for efficient collateral management.” 

Clearstream, another international CSD, has created the Global Liquidity Hub, a solution that aims to reduce collateral fragmentation. Stefan Lepp, head of global securities financing at Clearstream Banking, says that global investment banks, for example, are constantly confronted with the challenge of covering their exposures. “To avoid penalties, all these globally operating institutions hoard much more collateral than they actually need,” he says.

If an institution, for example, operates in 25 markets and holds $1bn in each, that is already $25bn. “It means they are not in a position to optimise the collateral,” says Mr Lepp. “We want to ensure our customers are able to leverage the collateral positions in individual locations in real time, without forcing these customers to transfer out specific positions. With us sitting in the middle as a liquidity hub, we are able to identify the fragmented local collateral and then marry the collateral in individual markets and build a pool to be able to optimise its use.”  

Joint enterprise

Clearstream was one of the parties of an industry association that was announced in January 2013. The Liquidity Alliance was formed with four other CSDs – Australia’s ASX, Brazil’s Cetin, Spain’s Iberclear and South Africa’s Strate – to address the global collateral crunch. CSDs have a key role to play in optimising the use of collateral, according to Monica Singer, CEO of Strate. She says that collateral in the past has mainly been cash and now “that cash is becoming scarce”, adding that the next best thing is high-quality securities.

“Where are those securities? Being held in an account in the CSDs around the world,” she says. “In South Africa, we have to give access to these accounts that are sitting there doing nothing.” 

Ms Singer explains how Clearstream’s solution works for Strate: “The securities do not have to move outside South Africa – they remain in a segregated account.” She adds that with this solution, Strate does not have to transfer the securities to Clearstream. “They are under my control and I can move them from one account to the other in our books,” she says. 

Safety awareness

While much focus has been on creating virtual pools of collateral that the various market participants can access, there is also the contentious issue of whether safe assets can be manufactured. The need is all the more acute with the safety or otherwise of vast amounts of sovereign debt in the eurozone now under the microscope.

Gary Gorton, a professor of management and finance at the Yale School of Management, says: “An economy needs a certain amount of safe assets – for example US treasury bonds – but when there is not enough, the private sector will produce substitutes.” He explains that in the US, the percentage of safe assets – including those that are privately produced – to total assets has remained stable at about 33% since 1952. 

He adds, however, that the private production of safe assets – through securitisation – has collapsed since the financial crisis. While the subprime crisis and the collapse of Lehman exposed how assets that were deemed high quality were not safe, the European sovereign debt crisis has in any case also changed the perception of which assets are considered to be safe.   

According to the April 2012 International Monetary Fund Global Financial Stability Report, the number of sovereigns whose debt is considered safe has fallen, which could remove $9000bn from the supply of safe assets by 2016, or roughly 16% of the projected total. “When there is a shortage of government collateral, the private sector invents substitutes. That will happen again,” says Mr Gorton. 

Keep it simple

But not everyone is convinced that this is a positive development. Mr Zeeb at Six Securities says: “The thing that worries me more than getting to a solution of how to mobilise collateral is the idea that we can create new collateral and new securities. The idea that repackaging securities is the way forward is absolutely terrifying. Collateral has to be simple, high quality, liquid and easily valued.” 

And in terms of the margin that is needed for derivatives transactions, there are calls to widen the definition of what good-quality collateral is. Ms Shin-Kobberstad refers to the consultative document put out by the Bank for International Settlements and International Organization of Securities Commissions. The paper, which was released in July 2012, proposed that a broader range of assets – including equity securities and corporate bonds – should be considered as eligible collateral. “They are expanding the idea of high quality,” says Ms Shin-Kobberstad. 

She notes that CME Group was one of the first CCP clearing houses to expand its definition of collateral. It now allows corporate bonds to be pledged as initial margin for cleared OTC interest rate swaps. And LCH.Clearnet’s SwapClear accepts US mortgage-backed securities as collateral for initial margin. 

The race to the bottom

While some observers view this as a loosening, or relaxation, of the standards, such moves seek to address the issue of collateral scarcity. Nicholas Newport, a managing director of risk management consultancy Intedelta, says: “If you loosen eligibility and allow different types of assets to be placed as collateral then absolutely you have relaxed the credit risk management framework and increased the appetite for risk. What is key is that there is a balance between credit risk and liquidity risk. If there is a collateral crunch then you are potentially creating liquidity risk issues.” 

The broadening of the margin requirements coincides with the broadening of eligible collateral for Basel III’s liquidity coverage ratio. In January 2013, the Basel Committee on Banking Supervision approved revised rules so that banks are able to count a wider range of assets in their liquidity buffer, which includes equities and mortgage-backed securities.

When it comes to CCPs broadening eligible collateral, there are concerns that standards may deteriorate as competition between CCPs increases and will create a ‘race to the bottom’.

“Small CCPs are popping up everywhere,” says Ms Shin-Kobberstad at Moody’s, adding that custodian banks are setting up CCP-like functions. And aside from increased competition and the broadening of the definition of collateral, there are other practices that are also evolving from the new regulatory environment.

New practices

David Field, executive director of consultancy Rule Financial, points to the practice of cross-product margining. Typically, the margin is worked out for each product and the collateral is posted to the CCP. With cross-product margining, Mr Field says, the broker is able to look at the products across a whole portfolio. By looking at the liability across a range of products, the broker is able to offset positions within the portfolio and thus calculate a lower margin requirement. There is an argument, however, that with this method the risk remains the same but the amount of collateral that is posted is less. 

On the question of whether risk is being increased and CCPs are competing in a ‘race to the bottom’, Mr Field says: “CCPs are very prudent and risk averse. They do not want to compete on that basis. They are demanding high-quality assets. Where they do broaden eligibility, they typically put a much bigger haircut on lower quality collateral.” 

James Malgieri, global head of service delivery and regional management for BNY Mellon’s global collateral services business, says that before any theoretical race to the bottom with CCPs will take place, there will be a natural shrinkage in the marketplace. “Certain market players entering into these transactions did not have to post collateral before, so there was not a cost built in. Now they have to post collateral, so some people just won’t want to do the investment and so the markets will naturally shrink,” he says. 

Mr Zeeb has concerns about the basis on which CCPs will be competing with each other. “If we have CCPs actually competing on what kind of collateral they are prepared to accept then we are sowing the seeds of the next financial crisis,” he says, adding that he believes in fair competition for CCPs, which is done on the basis of responsive real-time platforms and good client service, with appropriate regulation, “not on the basis of what kind of collateral you are prepared to take".

“I operate a fairly significant CCP and having good-quality collateral is critical, given the speed and the size of the transactions – we are sitting in the middle with risk on both sides,” he says.

Public sector solution

Because CCPs sit in the middle of transactions, counterparty credit risk is concentrated and CCPs are becoming the new ‘too big to fail’ institutions. “CCPs have to be bulletproof,” says Mr Philp at Everis.

There has been the suggestion that a monopoly or public utility model would be better for CCPs so that the risk is concentrated in a single place, much in the same way that liquidity risk is managed by a single central bank in each market.

“You could make the case that CCPs should be in the public sector, but the element of innovation is important in keeping up with developments in capital markets,” says Paul Tucker, deputy governor for financial stability at the Bank of England. “What the world is going for is private clearing houses that are subject to regulation by the state,” he says. A key part of that regulation is setting out the standards for margin requirements, the size of the default fund and loss allocation mechanisms. 

“Clearing houses are mechanisms for pushing the risk into the centre, which then has to be redistributed to the members of the clearing house, making the risks somewhat simpler and more transparent,” says Mr Tucker. “The people in the market have an incentive to say if the CCPs are not being prudent.”

Mr O’Connor at the ISDA agrees on this point and says there is a great degree of alignment between regulators and clearing house members. “While the clearing houses themselves have a certain amount of their own capital at risk, that capital is dwarfed by the capital put up by members in the form of default fund contributions and initial margin,” says Mr O’Connor. “The members have the most skin in the game.” 


The CCPs need to have a resolution regime, says Mr Tucker. “If a CCP goes bust, it does not have to go into liquidation. It can be resolved by an agency of the state without taxpayer solvency support,” he says. “These questions are important and are at the top of the agenda. The international and domestic authorities are already requiring CCPs to have loss allocation mechanisms and to be transparent to members. These CCPs need to be sound.”  


The increased use of CCPs was born out of a regulatory response to the crisis, and the increased margin costs could be having unintended consequences for the financial system. The margin requirements for derivatives mean that there is now an additional cost in sourcing the collateral. One consequence of this is that it is becoming more expensive to use derivatives to hedge risk and Mr Field notes that some buy-side firms may resort to imperfect hedges.

“That is all very well until the risk is crystallised and they realise that it is imperfect,” says Mr Field. “There is the potential for hidden risk to increase.”  


All fields are mandatory

The Banker is a service from the Financial Times. The Financial Times Ltd takes your privacy seriously.

Choose how you want us to contact you.

Invites and Offers from The Banker

Receive exclusive personalised event invitations, carefully curated offers and promotions from The Banker

For more information about how we use your data, please refer to our privacy and cookie policies.

Terms and conditions

Top 1000 2023

Request a demonstration to The Banker Database

Join our community

The Banker on Twitter