Collateral Transformation Services: What Could Possibly Go Wrong?

Risk has an interesting article ($) on the plans by some dealers to offer “collateral transformation” services to derivatives end-users. Requiring most derivatives to be cleared means that end-users will have to post daily variation margin to the clearinghouse (or “CCP”). Here’s how Risk describes the problem:

The problem centres on the type of collateral required by CCPs — or more specifically, the fact that many end-users don’t hold enough of it. Clearing houses only accept cash for variation margin, and usually insist on cash or sovereign bonds for initial margin. However, many buy-side users of derivatives tend not to invest in these assets — at least, not in the amounts that might be necessary.

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Clearing members [i.e., the dealers] say they have a solution. ... [C]learing members are responsible for collecting margin from their clients and posting it to the clearing house, charging a fee for the privilege. As an additional service, however, a number of clearing members are also planning to offer collateral transformation facilities — essentially, enabling the client to post non-eligible instruments with the dealer, which will be switched into cash via the repo market and then posted with the CCP.

So the plan is to concentrate liquidity risk at the dealer banks? Gee, what could possibly go wrong?



In all seriousness though, this is something that regulators should pay very close attention to. It’s easy enough* for dealers to tell regulators that their exposure is limited because the agreements are “unconditionally revocable” — that is, the dealer can unilaterally refuse to fund the client’s variation margin if the markets get too rough, and can demand that the client put up the cash. But it’s not nearly as easy for the dealer to tell its big hedge fund and pension fund clients to take a hike during a crisis. Think about it. If, say, Morgan Stanley refuses to fund a client’s variation margin call when the markets get volatile, the client will (a) be pissed, and (b) will start thinking, “What’s going on here? Is Morgan Stanley having trouble accessing the repo markets? If they can’t fund themselves in the repo markets, how much longer can they stay in business? Shit, I better pull my prime brokerage account at MS.” Then the run begins.



I’m not saying that no dealer would ever be able pull the trigger and refuse to fund a client’s variation margin. I’m just saying that this kind of arrangement could very easily turn into a non-contractual commitment to meet clients’ variation margin calls during a crisis. And that would undermine the dealers’ inevitable argument about how the unconditionally revocable nature of the arrangements means that the liquidity risk would be pushed back onto the clients — and away from the dealers — during a crisis.



So what should regulators do about “collateral transformation”? Well, for one thing, they should treat collateral transformation very harshly in Basel III’s Liquidity Coverage Ratio (LCR). Since these arrangements would almost certainly be structured as unconditionally revocable, they would be considered “Other Contingent Funding Liabilities” under the LCR. The run-off rate for “Other Contingent Funding Liabilities,” which determines the size of the liquidity buffer the dealers would have to hold against their collateral transformation arrangements, has been left to the discretion of national regulators. In addition to the run-off rate, national regulators also have to come up with assumptions for how much clients’ variation margins could move against dealers in the LCR’s 30-day stress scenario.



The safest route would be to set the run-off rate at 100% — that is, to assume that the dealers will fund 100% of clients’ variation margin through their collateral transformation services. A 75% run-off rate would probably be appropriately prudent as well — dealers will probably be able to say no to at least some clients, and will likely come up with other ways to mitigate some of the risk to themselves.



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* Actually, drafting and negotiating these types of contracts is a fiendishly difficult and contentious process, but that’s neither here nor there.