The interplay between liquidity and collateral

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Eileen Herlihy: Welcome to the J.P. Morgan Making Sense podcast. I'm Eileen Herlihy, and I sit within our Securities Services business, where I run sales for our collateral agency securities finance and custody FX business. I'm joined today by Michael Wynn, who's our global head of liquidity and FX within security services, and O’Delle Burke, who's our global head of margin services. We have a lot to cover today, but there are five main things we're going to try to spend time on. So firstly, liquidity. Clients obviously need to depend a lot on their custodian bank for intraday liquidity. So how are they managing it and what's changing? Secondly, the interplay between cash and non-cash collateral. So what are the practical realities for clients as they look to optimize? Thirdly, we want to spend a little bit of time on some of the operational solutions that we have for clients to do cross-currency deposits. And then no podcast would be complete without discussing T+1 and tokenization. So I'm very much looking forward to covering all those five topics with Michael and O’Delle today. It's fair to say we've seen a lot of change in the markets over our career. And Michael, you're in the hot seat. I'm going to start with you. So obviously, as a large global custodian, we have clients that are managing quite complex matters from a cash perspective. I guess managing between leaving cash on balance sheet and the operational ease that that brings, or else depending on the custodian for intraday liquidity. So what have you found most interesting as you've come back into this role here at J.P. Morgan in the last year?

Michael Wynn: Yeah, thanks, Eileen. So I think the biggest change we've seen is historically clients have been focused around the amount of cash they hold and the yield that it drives. But what we're seeing is in today's markets that really start to change as it relates to the liquidity that is available, very much more focused around intraday. We're definitely seeing the interplay between settlement, margin calls, and the different aspects of all of the investment profile through the day starting to create challenges. And clients are far more focused around that. And so as they start to think that through, looking at a much more engineered operating model as it relates to cash and liquidity. And so while the yield and where they deposit their cash from an end-of-day perspective still remains important, their ability to meet the intraday needs throughout the day is something that continues to be a key focus for them. And we continue to talk about that through many aspects of the cash cycle. And if I just touch on some of those things. What we look at or what we see from them is very much around the visibility intraday in terms of where do they think those inflection points are going to occur from the different aspects of their investment cycle.

Eileen  Herlihy: So is it they want more visibility from their custodian in terms of the stress points and the amounts of liquidity required?

Michael Wynn: Yeah, exactly right. It's very much understanding when those timings are going to hit and making sure that they've got sufficient cash flow throughout that cycle. And that has been something that has become much more of a focus. And obviously, the current market environment that we're going through with some of the market volatility has continued to show the importance of that and the level of focus from a client perspective around that.

Eileen Herlihy: And I guess you've got two things interplaying at once. To a certain degree, you should probably put more cash on balance sheet because there's more stresses during the day. But of course, cash is more resource constrained because of perhaps all the margin calls that are happening with the moves in the market. So it's a tough one to deal with those competing factors, I imagine.

Michael Wynn: Yeah, absolutely. And I think you rightly touch on, in an environment where you've got volatility, you don't want to be selling assets. And you've got increased margin calls, which sometimes can drive some of that behavior. Having the right liquidity in the right place and being thoughtful around the liquidity that you hold is incredibly important. And we're definitely seeing more of that in the on balance sheet side. So when we think about yield, we've seen an increased focus in terms of money market fund sweeps, and it's become the choice for clients. Certainly here at J.P. Morgan, and given our balance sheet, we have appetite for those deposits and to pay for those deposits on the basis of the stability of them, but also supporting all of their operational needs through the cash life cycle.

Eileen Herlihy: But of course, if there is a view that those cash balances can be pulled, then there is less stability inherent in them. Whereas if it is around more operational flow, there's a view that they are more stable. Well, shall I move on to you, O’Delle? Obviously, we spend a lot of our time in the collateral business thinking about cash versus non-cash collateral. And I guess that does have an interplay into Michael's world. But I know you're a keen follower of all the various ISDA surveys. Can you give us some of the latest themes, please?

O’Delle Burke: Yeah. It was interesting listening to what Michael was saying around stability, around cash positions,  I think in the collateral space, as you would expect, cash is a big component in terms of the assets that is used as collateral for bilateral and for tri-party activity. Securities, more and more, is becoming a big player in that space. Going to your question around stats, if we look at the stats from ISDA as it relates to cash being used as collateral, I think it has been the fourth consecutive year where we are seeing a decrease in terms of the use of cash collateral and an increase in terms of securities collateral. That said, cash is still king. So if we look maybe four years ago, the ratio in terms of cash collateral versus security collateral was 80-20. So 80% of the margins that are being covered is cash is being used as collateral. And then the 20% would be on the securities. If we fast forward to now, that number has changed to around 68% now is cash collateral is being used to cover a margin and the remaining 32% we're seeing securities as collateral.

Eileen Herlihy: While it's interesting to see that it has improved, I guess, i.e. there's more securities being used, I'm actually still surprised that it hasn't moved more. And I guess that's because while naively in theory one would say it's more optimal to post non-cash, there's operational challenges that one has to face. That's where you spend a lot of your day job, helping clients come over some of those operational challenges.

O’Delle Burke: Yeah, that's exactly correct. When you look at it in terms of cash versus securities, the two assets are not equal. When you get into the securities space, you have other administrative aspect that you have to think about with securities. So you have various sort of coupon related events. If you're talking about bonds, if you're talking about equities, you have dividends. So those are income related activity. On the equity side, you also have corporate events that take place. And while these assets or these securities are posted as collateral, we need to maintain those income events or corporate action events while these securities have been posted. So it becomes a bit of a challenge in terms of getting the benefit of using those securities as margin. And at the same time, make sure that any sort of asset servicing or safekeeping requirements are being addressed. I would say that's the biggest challenge. The other challenge to contemplate is that the movement of the asset, there's also a difference. So from a cash perspective, cash is relatively easy to move in the market in terms of moving it from one counterparty to the next. From a securities perspective, you always have that risk of failure. Especially if you're doing bilateral movement of securities. If you're doing securities movement or exchange of securities collateral within a tri-party format, then you can start to mitigate some of those operational risks in terms of potential settlement fails.

Eileen Herlihy:  That is surprising sometimes that the buy side doesn't use it more. And I know there are some nuances around reuse, et cetera, that make that difficult.  But there's a few things you have to consider, as you discussed. The operational complexity. And of course, I guess cash is easiest, then it's bonds, then maybe it's corporate bonds, and then hardest is equities. But then, of course, there's the pricing impact. If you ring up your dealer and you say, ‘I want to change my CSAs,’ they're going to naturally say, ‘Well, there's an economic consequence of that.’ And it is marrying those two sides, the operational side and the mathematical optimization side together and how you marry the two. So, I think that's a flavor of the conversations that at least I've been having. And I think that you've been having with our clients around the world.

O’Delle Burke: Absolutely. And you mentioned an important aspect that sometimes get overlooked. So, you have the operational aspect that I mentioned before, and there are areas that you can really gain efficiency in terms of having the proper operating model to enable you to use on securities as collateral. But the aspect that you mentioned around the documentation that sometimes get overlooked. So while the two parties might agree that, O.K., they want to use a new asset type, equities, for example, as collateral for variation margin. Now, what that takes in some cases or probably most cases is to update the CSA documentation. And when it comes to the legal space, it doesn't move very quickly in terms of making those changes. So I think that's one area that the clients would need to consider making those changes to facilitate the use of securities, in this example equities as collateral.

Eileen Herlihy: And I think as well, there's no one-size-fits-all, which I know is such a truism. But so, you're never going to post equities to collateralize a 30-year swap. It's going to change your discounting too much. Whereas maybe you can post equities to collateralize a one-year FX forward.  You have to be very mindful that if you're going to post equities as collateral, it's going to be for a small proportion of your derivatives. But even freeing up a small proportion of your portfolio can be helpful in a stressed environment.

O’Delle Burke: Absolutely. And the idea is right now, especially looking at our client base, the level of sophistication is growing. In terms of the instrument that they are trading. And as they trade these instruments, there is more requirements around the margin that's needed. So to your point, even if a small proportion of that book can be collateralized with equities or investment grade corporates, that is a huge benefit to the client in terms of starting to use some of the inventory that they have that is not currently being used. Because one of the biggest inefficiencies when you have unutilized or underutilized assets. And in the examples where we sort of gone through in terms of using securities collateral, the equities examples or using investment grade corporate, this is where they can get a bit more benefit of their current inventory.

Eileen  Herlihy: O.K., great. So let's move on to tokenization. Let's start with you, Michael, because obviously when you're talking with clients, it's a choice between leaving cash on balance sheet or moving to money market funds. And I guess nowhere has there been more noise about tokenization than in the money market fund space. So what are your views? Is it a game changer? Are you expecting to see huge changes in terms of how our custody clients deal with us and whether tokenized money market funds will replace traditional ones?

Michael Wynn: don't see that, certainly not in the short term. I think today really tokenized money market funds is really directed at digitally native clients. So where effectively they hold a lot of their assets in that digital space. And principally where I really see the opportunity is very much where clients hold stable coins. Today you can't get a yield on those stable coins and tokenized money market funds effectively give you the ability to access a yield. I think the tokenized money market funds space today is still small in the magnitude of what the size of the money market fund industry is. And it will grow. And I think the projections are $700 billion by 2030. So we'll definitely see growth in that space and they'll grow with stable coins as well. But I think in the real money institutional client space, I think it'll take a considerable amount of time for us to go there.

Eileen  Herlihy: And there's a certain irony, of course, because to do something in the traditional space, your transaction costs are quite small. Right. And of course, your cost of doing something per unit in the tokenized world is massive now because you just don't have the scale. But of course, nothing would ever get off the ground if you took that approach. But I do think when at least when I chat to clients about it is getting that investment because it is going to be additive. It's not like you're replacing your traditional rails today. So that's where it gets tricky. So let's move on to collateral. And of course, if ever there was a use case for tokenization, it is absolutely 100% collateral. And I hear great, I guess, hopes that, for example, perhaps margin period of risk, so imports could be reduced if your collateral can move more quickly. But finding the right use case can be tricky. So I've got many views on this, but O’Delle, I'll start with you. Where do you think tokenization has the power or already has changed the collateral space?

O’Delle Burke: Yeah. I think the way I would look at this is that from a technology perspective, it has proven itself to be quite promising. So I don't think there's an issue with the technology per se. And I think over time, it will become much more relevant, and broader acceptability will take place. However, I think the biggest sort of hurdle and maybe comes in two buckets right now when we think about tokenized collateral. The first bit is, you touch on it, which is the cost. From a commercial perspective, if the cost of using a tokenized asset is more expensive than traditional asset, it's just not going to go anywhere very quickly. And I think until we can drive that tech costs on operational costs much lower, either on par with traditional or better yet less than the cost of moving traditional assets. I think that's where it becomes a bit more promising.

Eileen  Herlihy: Indeed. And I also think though on the cost point, especially if we talk about money market funds, there's the operational cost. But as we discussed with broadening collateral eligibility and CSAs, it's around the impacts on the dealer if they were to accept a money market fund as collateral. And, it's been a big discussion point that tokenized money market funds should reduce the operational constraints around posting money market funds. Completely agree. But unfortunately, there's some other nuances in the market that has meant that not only the operational constraint is the problem. There is how does a dealer account for it? Can the dealer reuse a money market fund if it's posted to them as margin? What is the impact on their balance sheet and funding metrics? So what we found when we discuss collateral eligibility and tokenized money market funds is that every buy side client would love to post them as VM. But it's working with the dealers. And I do think there is progress being made now. There is an understanding that there is some regulatory and capital nuances that need to be ironed out.

O’Delle Burke: Yeah. And you just started to cover the second aspect of it, which is when you utilize a tokenized asset, what does it mean from a broker perspective? And the way to look at it is from the broker perspective, if they receive an asset as collateral and they can't reuse that asset for financing or margin purposes, it's a dead asset. And that means that it's going to be a cost to them in terms of balance sheet. The other aspect too, even before you entertain the exchange of tokenized assets as collateral, we talk about the legal aspect in terms of updating the documentation to facilitate that. From a buy side perspective, you also have the capital implications in terms of taking on lesser liquid assets. So when you go into securities or if you look at it from a tokenized perspective, there's an additional cost that comes with that. So when a buy side institution is looking to post, whether it's securities or tokenized assets as collateral, from a sell side perspective, the reuse aspect and also the impact in terms of the overall capital charge is a major consideration.

Eileen  Herlihy: I think there's lots going on in the tokenization space. And I would say with my tri-party hat on, we are blockchain agnostic. We are looking to integrate with the blockchains where our clients have demand to post and receive assets on. Because as you said, there's no point having a tokenized asset and then not being able to finance it. So connectivity to a tri-party platform is very key in terms of building that out. Many people also discuss that tokenization is very relevant in a world of T+1 .

Michael Wynn: Yeah, from a U.S. perspective, a lot of people now talk about it as a non-event. And it wasn't a non-event. There was a tremendous amount of work that went into the background to ensure that it was a non-event. As I think through to the UK and the EU and more broadly, there's definitely the level of focus has certainly increased again with the complexity that comes with that. In my space specifically, there's a big difference, I think, between the asset manager segment and the asset owner segment. Asset managers have the full breadth end-to-end visibility of everything that they're doing for their fund ranges. And so therefore, it's much easier for them to understand the operating model, understand the liquidity profile, understand the FX requirements of their portfolios and therefore how they manage that across the cycle. I think for asset owners, where you have a combination of in-house management and external management, that changes and it becomes more complex because you have less control of the end-to-end operating model. And that delivers some challenges in terms of the way you think about, if we talk about liquidity, how you optimize your portfolio from a cash perspective. What is the timing? I talked about before the intraday requirements of cash and liquidity. How does that show up across a portfolio where you aren't fully in control and you're relying on external fund managers to manage that money for you? And so I think what we see is a combination through some of the conversations that we've been having around and thinking more specifically in the foreign exchange space is, when do clients send in their messages? When do they do their foreign exchange transactions? And in a shortened T+1 settlement cycle, that level of focus and requirement to try and net and aggregate foreign exchange transactions, ensure that cash is available when it's required from an intraday perspective becomes more important. And so the timing of when we receive securities messages, the timing of the FX execution and delivering that end-to-end operating model does become more important. And I think data is also a key component for asset owners in terms of that operating model. Their ability and visibility into when things are occurring become really important.

Eileen  Herlihy: So you think that it may mean more clients outsourcing their  securities-related FX?

Michael Wynn: I think so. I think asset owners will take a more holistic view of their portfolios. They choose investment managers for the purposes of the asset class that they want to invest in. But things like cash, liquidity, and foreign exchange, I think they want to see much more centrally and think about it more holistically across the portfolio. And therefore, optimizing it, centralizing it, and optimizing it through an outsource solution I think is becoming a more viable and favorable solution that clients are selecting.

Eileen  Herlihy: So we've covered a lot, and I think there's lots more we could cover. But I think they do all coalesce around the same theme. That for clients, there's a lot going on. They have to be much more mindful around what they do with their cash, how they interact with their custodian in terms of intraday spikes, etc. How they look at collateral and whether they decide to free up cash in their portfolio by posting other things. And we really only today did touch on what we do as a collateral manager. We may not always have the answers, but I'd like to think we do know most of the questions between us. So before I finish it, is there any final remarks you'd like to make, O’Delle?

O’Delle Burke: Yeah, I think maybe going back to the theme around optimization.  I think the mantra has always been cheapest to deliver. And I think at this point, we're seeing that sort of change into most resilient to fund, given everything that we see happening from a market or from a geopolitical perspective. So I think that's one to keep in mind. The other thing is that fragmentation of asset pools is here to stay. That's not going to go away. The ability to access those various asset pools across custodians or across tri-party agents is going to be critically important. So, we spend a lot of time with our buy-side clients working through that. And then the last one that I will leave with you is operational resiliency. And this has to do with, , looking at the overall portfolio activity. How does that grow in terms of  having enough scale and bandwidth within your infrastructure, whether it's, , from a technology perspective or from your team standpoint to be able to support that.

Eileen Herlihy: In one of my recent meetings, a client had a great term. He said, ‘I'm optimization curious.’ I'm not sure what it means just yet, but I'm definitely interested. So hopefully any optimization curious people out there can get in touch with us. And what about you, Michael? Anything final that we haven't touched upon?

Michael Wynn: Yeah, I think, look, I thought what O’Delle said really resonated. For me, from a custody and trading services perspective, the opportunity for us is to really help our clients treat liquidity like an operating system, connecting balances, flows, rails, and balance sheet tools so they can reduce their idle cash, avoid exceptions, and really stay resilient. Back to that stress point, stay resilient when the market gets noisy.

Eileen Herlihy: O.K., great. Well, thank you very much for taking the time, and I look forward to continuing the conversation at many points in the future.

Michael Wynn: Thank you.

O’Delle Burke: Thank you.

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