A New Role Ahead for SWFs and Pensions: Collateral Transformers

February 26, 2015 by Loch Adamson

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Yngve Slyngstad is CEO of Norges Bank Investment Management

New capital regulations have opened a door for sovereign wealth funds who want to profit from a growing scarcity of high-grade collateral. That could be a risky business.


Last November, at a seminar in Oslo, Yngve Slyngstad, CEO of Norges Bank Investment Management (NBIM), made a comment that had certain audience members abuzz with curiosity. The head of NBIM, which oversees Norway’s $860.8 billion Government Pension Fund Global , mentioned cryptically that the fund was looking to expand into "more specific types of liquidity commissioning strategies." Slyngstad did not elaborate — and many seminar-goers either missed the reference or simply scratched their heads.

But some attendees believe these strategies Slyngstad mentioned involve something that in industry argot goes by the name of "collateral transformation". They point out that NBIM’s custodian, New York-based Citigroup , is one of the banks that has started offering the somewhat esoteric service.

While collateral transformation is a new, little-understood business, the basic idea is relatively straightforward. Say an asset manager needs to post collateral for a derivatives trade at a clearing house, but lacks the necessary high-quality securities — it may have only U.S. corporate bonds, for instance, when it needs Treasuries. If the manager goes to the right bank it can make an exchange for the eligible bonds.

For its part, the bank will charge a haircut, or fee, to compensate for the increased risk it takes on by swapping the assets. The process is known as an "upgrade trade" and enables the bank to realize a tidy profit.

Now, sovereign wealth funds are angling to play the role of banker in such deals, says Brian Leddy at Bank of New York Mellon Corp. ’s Global Collateral Services department, which is working with several sovereign clients. Some are showing keen interest in his firm’s own collateral transformation service. "The ability to transform securities will become even more of a revenue-generating opportunity," he says.

Linkages

The market for such trades grew out of of post financial crisis regulation. It serves as a textbook case of how new rules generate unintended consequences as well as opportunities.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and European Market Infrastructure Regulation (EMIR), first passed in 2012 — both require that investors clear over-the-counter derivatives trades through a central counterparty clearing house (CCP), and post high-quality collateral, like Treasury bonds or blue-chip stocks, to prevent financial contagion in a crisis.

But Basel III bank rules and U.S. Federal Reserve-mandated stress tests of systemically important financial institutions require increased high quality assets, like Treasuries, on bank balance sheets as a cushion against future volatility. Such high-grade assets, however, have grown scarce as a result of the massive bond buying program known as quantitative easing in the U.S. and will grow increasingly so as the European Central Bank revs up its own bond buying program next month.

Spotting the trend early, Jeremy Stein, then a governor on the board of the Federal Reserve , warned in February 2013 that regulators should be "watchful" of activities like collateral transformation. He argued that they may create structural linkages that could prove flammable in the event of another crisis.

Risk and Reward

With the increased capital restrictions, banks have little wiggle room to perform this service on their own balance sheets, so they are increasingly acting as intermediaries, connecting those in need of eligible collateral, big derivative traders including hedge funds, and those that are in a position to provide it. Sovereign wealth and pension funds, with their vast supplies of low-yielding, high-quality securities, fit the bill. And many pensions and state-owned investors are eager for the extra income, how much depends on the specific trade, in an era of low yields and dampened economic expectations.

New collateral management strategies are garnering more attention these days — and though still in their infancy, they bring with them possible new hazards — both for sovereign wealth funds, which are taking riskier assets onto their balance sheets as part of these strategies, and to the wider financial system.

Bank of New York Mellon’s Leddy says that although uptake thus far has been relatively limited, demand will likely increase as the new regulations are implemented and the collateral squeeze becomes more pronounced. "There’s still a high level of caution among sovereigns about what they want to do in this space and how to strike the right balance between risk and reward," he says.

Collateral transformation has inherent hazards: By definition the sovereign wealth funds that participate will be removing safe, liquid assets from their balance sheets and replacing them with riskier ones. And the risks may be particularly acute if funds begin to in-source collateral transformation to try and cut costs. The Sovereign Wealth Center has learned that several funds are exploring this possibility.

Market Contagion

Collateral transformation is a multi-stage, time-sensitive process, and sovereign wealth funds that want to do it themselves will need to ensure they have the skills required to perform all of the necessary functions. These include assessing counterparty exposures, valuing the collateral lent and tracking the underlying derivative instruments to gauge the appropriate charge needed to cover the increased risk, and settling any disputes with counterparties quickly and efficiently. All this requires sophisticated data management techniques, not to mention substantial human resources.

Sovereign wealth funds’ involvement in collateral transformation could lead to wider problems, too. Some economists agree with Jeremy Stein that by lending securities as collateral, sovereign wealth and pension funds may be fostering new linkages and connections that actually increase the risk of market contagion — the opposite of the effect intended by the regulators when they insisted on the shift to centralized clearing for derivatives.

"CCPs are meant to reduce risk," says Manmohan Singh, a senior economist at the International Monetary Fund in Washington D.C. "But guess what: once you start posting collateral in CCPs via the large banks, which are the clearing members for CCPs, then you create more links between the banks and the non-banks. That makes the system more contagious."

On balance, however, Singh says that the benefits to market liquidity outweigh the increased counterparty risks. By circulating their securities and facilitating the free-flow of capital, sovereign wealth funds could help the financial system become more resilient overall.

Nevertheless, collateral transformation is a new and quickly-developing industry. While state investors could make considerable sums of money by getting involved, the potential impact on the wider markets is still unclear. Like all such innovations, the collateral business is likely to bring with it a combustible mix of risks and opportunities.


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