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Regulatory Considerations and Collateral Implications

Since the first Group of Twenty (G20) summit in November 2008, regulations continue to evolve and be introduced across jurisdictions. Understanding these rules and their impact on efficient collateral management has become increasingly business-critical. Three key areas that impact collateral management are:

  • Collateral haircuts
  • Collateral segregation
  • Re-use of collateral

Collateral haircuts

Having both the right collateral tools and a clear understanding of the impact of regulation on collateral could create a competitive edge for institutions.

Historically, market participants agreed to apply a haircut to reflect the potential price fluctuations of collateral received. Haircuts range from zero on cash or government bonds to 25 percent (or more) for listed equities or highly structured bonds.

A piece of collateral can be subject to varying haircuts and relative values depending on the instrument type or the clearinghouse where it is cleared. Given these variables, market participants need strong analytical tools to review the collateral inventory and the relative value of each collateral component in order to be efficient and mitigate disputes.

Collateral segregation

Segregation of house collateral from client collateral is already an established practice. Collateral segregation aims to reduce the risk of client assets being treated as the property of the securities intermediary in the event the securities intermediary becomes insolvent.

Market participants may require further segregation of posted or received collateral, which makes the safekeeping and efficient management of collateral assets operationally more challenging.

Re-use of collateral

Market participants need strong analytical tools to review the collateral inventory and the relative value of each collateral component in order to be efficient and mitigate disputes.

Today the re-use of collateral is an essential tool for liquidity and financing. It maintains the flow of collateral, lowers the overall cost of trading and creates financing opportunities. In the future, there is an anticipated increase in demand for quality, highly liquid collateral. However, certain regulatory developments may restrict the re-use of collateral. These limitations may require market participants to acquire and deploy more 'fresh' or non-re-used collateral.

FIG-01: Regulators have recently focused on haircut levels.

Regulation Affects Model/Impact
Dodd-Frank Act and European Market Infrastructure Regulation (EMIR) Cleared derivatives Central counterparties (CCPs) determine the haircuts they set for the various collateral classes they accept to reflect credit, market and liquidity risks, likely creating different models across CCPs.
BCBS/IOSCO Key Principles Uncleared derivatives Market participants have a choice of two haircut models: either an internally developed and regulator approved model (approved by the regulator in each country where such model is used) or a standardized initial margin schedule as set by BCBS/IOSCO.
Financial Stability Board (FSB) Repo market
  • Recent market consultation suggests minimum haircuts for uncleared repo transactions between a regulated and a non-regulated entity.
  • Through the introduction of numerical haircut floors on certain transactions, the FSB aims to limit leverage and reduce pro-cyclicality outside the banking system.

FIG-02: Dodd-Frank, EMIR, AIFMD, UCITS and the Key Principles of BCBS and IOSCO reinforce the need for collateral segregation.

Regulation Affects Model/Impact
Dodd-Frank Act Cleared derivatives Legally Segregated Operationally Commingled (LSOC) model requires the segregation of house collateral from client collateral.
European Market Infrastructure Regulation (EMIR) Cleared derivatives Requires:
  • Segregation of house collateral from client collateral.
  • Clearing members and CCPs offer clients the opportunity to have their client collateral segregated in individual accounts, away from other clients' collateral. In this case, the risk of shortfalls arising in other client pooled accounts should not result in shortfalls in the segregated client's account.
BCBS/IOSCO Key Principles Uncleared derivatives
  • Recommends holding the collateral provided as initial margin in such a way that the collateral provider is protected if the collateral receiver enters into bankruptcy.
  • Use of third-party custodians could meet this segregation requirement.
Alternative Investment Fund Management Directive (AIFMD) All collateralized transactions
  • AIFMD requires a depositary to segregate house assets from client assets.
  • AIFMD requires AIF assets to be clearly identified as belonging to the AIF in the accounts of the depositary.

FIG-03: While the terms rehypothecation/re-use are often used interchangeably, they can differ in interpretation and treatment depending on the regulatory body.

Regulation/Regulatory Body Definition and Ruling/Recommendation
Financial Stability Board (FSB) Policy Framework for Addressing Shadow Banking Risks in Securities Lending and Repos, August 2013 Defines re-use as "any use of securities delivered in one transaction in order to collateralize another transaction," while rehypothecation is the re-use of client assets. In its policy framework, the FSB recommends that only entities subject to adequate regulation of liquidity risks should be allowed to engage in the rehypothecation of client assets.
BCBS/IOSCO Key Principles for Uncleared Margining
  • While the key principles do not make a distinctive difference between rehypothecation and re-use, they allow rehypothecation of initial margin only under very strict and limited circumstances to hedge a position stemming from a trade that led to the first requirement to post initial margin.
  • Allows variation margin received as part of derivatives trades to be re-used by the receiver on an unlimited basis, subject to any applicable local regulatory requirements.
European Commission Proposed Rules for Money Market Funds 2013/0306 Draft rules prohibit the re-use of collateral received as part of a repo transaction by a money market fund.
ESMA Guidelines on UCITS Guidelines indicate that non-cash collateral received by a UCTIS fund should not be sold, re-invested or pledged—effectively ruling out rehypothecation.

Regulatory developments have different implications for an institution's ability to rehypothecate and/or re-use collateral. This increases the demand for quality, highly liquid assets and the need to have a single, clear view of counterparties, assets and obligations.

Outlook for 2014

The ninth G20 summit will be held in Australia in November 2014, by which time it is anticipated that:1

  • Mandatory clearing will have commenced in Europe following the U.S., which started in March 2013.
  • BCBS will have developed internationally consistent, risk sensitive rules for capital treatment for banks engaged in shadow banking activities and will provide an update on reform implementation to mitigate banks' interactions with shadow banking entities.
  • FSB will have completed recommendations on minimum standards on methodologies for calculating haircuts on non-centrally cleared securities, developed information-sharing process within its policy framework for shadow banking, and proposed standards for global data collection regarding repo and securities lending markets.

Having both the right collateral tools and a clear understanding of the impact of regulation on collateral could create a competitive edge for institutions.

1 Russia G20, "Roadmap Towards Strengthened Oversight and Regulation of Shadow Banking," September 2013, www.en.g20russia.ru.Weblinking Icon.

2 Sources: Finadium, Morgan Stanley, Bloomberg, TABB Group, Bank of England and the Bank of International Settlements.

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Subject Experts

John Rivett John Rivett
Global Executive
Collateral Management
Regulatory and Industry Affairs, J.P. Morgan Investor Services
Mark Trivedi Mark Trivedi
Global Product Head
for Collateral Management, J.P. Morgan Investor Services

Key Takeaways

  1. Initial margin requires more collateral—Industry studies estimate that the amount of incremental collateral required by new regulations for both bilateral and centrally cleared trades could range from US$500 billion to $5 trillion.2 This will phase in as existing trades mature and new trades are booked. Ultimately, the scope will depend on the final rules for margining uncleared derivatives, the efficiency of netting processes at the CCPs, and how and whether collateral receivers and collateral providers change their practices.
  2. Transparency and reporting—Having the flexibility to view and report collateral assets with supporting data references (LEIs, UTIs, etc.) by entity will support market participants' regulatory requirements across various jurisdictions.
  3. Understanding the end-user requirements—European funds appoint depositaries who have liability for safekeeping of assets under AIFMD and UCITS. This is increasing the need for segregated collateral accounts. As a result, fund managers and agent lenders need to manage across more accounts, and collateral providers need to meet smaller requirements across a greater number of accounts. Management of eligibility schedules and concentration limits for collateral receivers across their derivative, repo and stock loan obligations, and collateral providers' ability to efficiently optimize quality, highly liquid assets becomes increasingly business-critical.

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