Citi targets “dangerous” global collateral shortfall

Basel III, EMIR and Dodd-Frank could produce collateral shortages

Citi has established a set of alliances with Clearstream and Euroclear Bank that it says will transform the way broker-dealers manage their collateral, freeing up precious resources as onerous new regulations in the US and Europe burden banks with tougher collateral requirements.

Previously, broker-dealers would work out which assets to collateralise and then move them from their own trading accounts to the tripartite agent who would manage the collateralisation. However, under the new deal with Citi, the  agent will now instruct the collateral moves on behalf of the broker-dealer, potentially making the whole process easier.

Equity and fixed-income assets held at Citi will be available for use as collateral through the tripartite services of Euroclear Banka and Clearstream. The idea is that customers will retain their asset portfolios within Citi’s custody network, while using the collateral management engines of Clearstream and Euroclear Bank to carry out the more complex collateral management.

A spokesperson for Citi added that the agreements should make collateral management less of a burden for the broker-dealer, as well as more efficient, as the collateral will now be pooled at a central point.

The need for more collateral has been fuelled in recent years by the advent of regulations such as Dodd-Frank in the US, EMIR in Europe and Basel III, all of which mandate higher collateral requirements for banks. In particular, Dodd-Frank and EMIR both require the central clearing and reporting of the majority of formerly OTC derivatives contracts – a demand that means banks will have to source collateral as margin at CCPs.

The intention behind the regulation is to cut down on systemic risk in financial markets and to shore up the resilience of major financial institutions in the aftermath of the financial crisis. However, it has been estimated that collateral shortages may impact investors in developed markets as the new rules take hold. According to research published by BNY Mellon and Rule Financial in December, the amount of initial margin that must be sourced can be substantial – around 1-3% of the notional value of the contract for a typical 5-year vanilla interest rate swap. For long-dated or complex contracts, the amount of collateral required increases substantially because of the greater potential future exposure, to around 10% of notional for a 30-year and 15% of notional for 50-year tenors. In addition, the Investment Management Association has identified as “not unusual” the requirement for CCP-eligible collateral equivalent to 20% of the investment value of test portfolios to be able to meet initial and variation margin obligations on typical OTC derivatives strategies under mandatory clearing.

With a difficult macroeconomic situation in Europe and the US, Denis Peters, director of marketing and communications at Brussels-based Euroclear, warned Banking Technology Peters that the situation may become even more difficult if more institutions receive credit rating downgrades, reducing the available supply of high-quality collateral. Adding to the danger, the BNY Mellon-Rule Financial research found that only 20% of buy-side firms have finalised their adjustments to meet the new rules, despite the fact that they are due to take effect in the US this year and in Europe from 2014.

Firms such as Euroclear typically look for assets in the collateral giver account and move it to that of the collateral taker. If there is a need for more collateral, the clearer will ask for it; if there is too much, the clearer will return it. If there is a need to move particular assets held as collateral, the clearer will automatically source and substitute other collateral. According to Peters, the main advantage of the deal with Citi is that his firm will be able to look into Citi client accounts, broadening the collateral that it can use on behalf of clients.

“Collateral takers can be buy-side firms, custodians, CCPs or central banks,” he said. “This is in line with the concept of Euroclear’s collateral highway service, which sources collateral from all the firm’s central securities depositories, agent banks such as Citi, clearers and CSDs located in any time zone to make sure that collateral moves to where it is needed, drawing on a broad pool of different market participants and institutions.”

Citi is planning to continue the roll out the collateral management scheme in Europe in Q1 this year and plans to expand the solution to Asia and the US later, depending on client demand.