Common Challenges, Different Perspectives: Views from the Sell-side

Editor's note: This article and the next are adapted from discussions that took place at J.P. Morgan's recent collateral management conferences, "Perspectives on a Changing Reality: Managing Collateral in 2012 and Beyond," held in London and New York. Buy-side and sell-side panelists included representatives from American Express, Credit Suisse, European Bank for Reconstruction and Development, HSBC, IGNIS Asset Management, J.P. Morgan Investment Bank, J.P. Morgan Securities, Morgan Stanley, Northcross Capital, PricewaterhouseCoopers, Royal Bank of Scotland, Société Générale, Standard Chartered and UBS Global Asset Management.

Regulation has become the driving force for sell-side institutions—looming in the background to influence every key business decision. For the sell-side, the biggest impact is likely to stem from the revised Basel regulations, which define both stricter capital and liquidity requirements (e.g., the Liquidity Coverage Ratio or LCR), European Market Infrastructure Regulation (EMIR) in Europe and Dodd-Frank in the U.S.

Globally, regulatory changes are forcing the sell-side to reconsider current activities and business models as riskweighted assets (RWA) and balance sheet rationalization put pressure on revenue generation and spending. The search for funding drives the sell-side to complement old sources with new alternatives (such as collateral transformation), to seek new counterparties or to expand the range of acceptable collateral assets. At the same time, the need to efficiently utilize all assets most effectively forces a shift to enterprisewide collateral management. Global regulatory pressures are supplanting traditional market drivers and changing business behavior. Institutions are faced with three categories of challenges:

1. New pressures—on capital, liquidity, pricing and costs
2. Changing variables—in terms of funding options and sources (such as accessing new counterparties and market participants) as well as how assets are employed
3. Increased demands—for optimization, reuse and upgrades as well as for enterprisewide collateral management

New pressures

Institutions must weigh the competing pressures that are changing the environment in which they do business against their own business priorities.

• Capital — The amount of capital required and the composition of that capital are being driven by upcoming regulations, particularly new Basel rules. Individually and collectively, these set higher minimum standards for the amount of capital held on balance sheets and, as a result, create internal competition for available capital and financing for existing business activities. Regulations are also affecting how firms are pricing their services as they become more granular in the internal allocation of capital across their business activities.
• Liquidity — As the amount of high quality, highly liquid assets on balance sheets increase to comply with regulatory pressures, the ability for certain firms to lend or take on other liabilities may decrease. For others, the increased demand for high quality collateral may outrun supply. Liquidity in certain products may also be challenged as more business activities compete for the same assets to meet the emerging requirements of central counterparties (CCPs) for cleared derivatives trades (a hallmark of both Dodd-Frank and EMIR).
• Pricing — Pricing discrepancies are emerging across the markets as, in some instances, the asset is no longer the primary determinant of the repo rate. Rather, greater divergence between institutional credit ratings is driving different rates, more strongly reflecting the perceived risk of the transacting counterparty.

• Concurrently, regulations increasingly require that intracompany transactions be collateralized, limiting historically favorable treatment of internal counterparties versus external ones. As these pressures affect pricing, the institution's underlying clients may be challenged to understand the rationale behind different spreads for the same product, or why spreads and rates don't reflect the same market drivers today as they have historically (e.g., rates increase despite low interest rates).

• Costs — Ultimately, increased prices and costs will have to be absorbed within the organization or pushed out to the end investor. The path chosen may largely depend on the size of the institution. While larger institutions may be able to absorb a little more of the cost internally, others may more aggressively push the costs through to the end investor. As a result, at the same time that fee structures become more volatile, costs overall may increase. This is exacerbated by the continued instability driven by ongoing regulation and the uncertainty as to the timing of its implementation. Although the market continually prices in and absorbs changing market conditions, the apparently endless stream of regulation has created a choppy road to stability.

Changing variables

Funding sources, new market participants and collateral availability will be critical to future market operations. Given the pressures above, where will funding come from, and will non-traditional players emerge as collateral providers? Will equities be more sought after as acceptable collateral, or will "cash be king?"

• Funding sources — Challenged by regulations that increase capital requirements, traditional sources such as unsecured interbank financing are already on the retreat. This is not only a reaction to the financial crisis but also anticipates future liquidity and funding requirements under the new Basel framework, which is designed to promote the shortterm resiliency of a bank's liquidity position.
• Given the widely expected $2 trillion dollars needed in collateral for CCP-cleared OTC derivatives, will nontraditional but cash-rich lenders, such as corporations and non-bank financial institutions, enter the market in greater numbers? Likely not, as historically these institutions have preferred the predictable yield and tenor of fixed income securities. However, pensions and money market funds — which fall outside the scope of the Basel framework and thus face fewer restrictions — could become a new source of market liquidity.
• Equities — Will equities be more widely accepted as collateral? Overall, although the use of equities as collateral is on the rise, liquidity demands may stymie significant growth unless equities are ultimately accepted as liquidity buffers or counted against capital requirements. (Those conversations are active and ongoing at the time of publication.)

• Cash — Is cash "king" in margin maintenance? With a market awash in cash, that's certainly one option, particularly if equities are no longer "cheapest to deliver." This is counterbalanced, however, by two simple facts. First, although taking cash is often the least expensive alternative, not all institutions are set up or able to accept it for all transactions. Secondly, cash collateral received may not help an institution to meet its LCR requirements if such collateral has to be returned to the counterparty within 30 days. Once all the effects of new regulation are taken into consideration, institutions must change how they manage their balance sheets to use capital wisely for transactions that meet their individual risk-reward profiles.

Increased demands

Although the questions posed above will be answered over time, what's clear today is that these changing markets demand sophisticated solutions for coping with new requirements and increased complexity.

• Collateral optimization — To meet collateral and margin requirements for cleared derivatives trades, institutions will engage in more collateral transformation activities. Collateral upgrade trades, along with short-term money market trading, are likely to rise as institutions seek more liquid assets and strive to lock in term liquidity. At the same time, efficient processes that support collateral reuse will be essential as institutions seek to utilize all assets to their greatest advantage.
• The ability to optimize collateral will create a competitive advantage for those institutions that can reduce their funding costs and better allocate assets internally.
• Enterprisewide collateral management — Institutions will have to assess how and where they hold collateral, along with how they fund and manage activities. Replacing separate desks (segregated today by region or asset class) with a single global funding model may help them mobilize a pool of assets efficiently in the post-regulation environment.

Conclusion

One final factor to consider is the uneven playing field caused by regulations that are not fully aligned. As institutions comply with various regulations, which differ in terms of region or scope and demand diverse levels of compliance depending on the industry or type of business, the rules for remaining competitive have changed.

Global institutions must nimbly navigate competing challenges — managing cost alongside balance sheet, maintaining liquidity while leveraging assets, and managing risk on multiple fronts — and make key strategic decisions without a clear view of the terrain that lies ahead. As the sell-side faces increased complexity, the ability to seamlessly operate across regions and asset classes becomes critical to success — causing many institutions to seek expert support from collateral agents with the global reach, expertise and resources to provide essential support in changing markets.