Amid New Regulations, SWFs Use Collateral to Generate Profit

February 23, 2015 by Loch Adamson

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The Federal Reserve's quantitative easing program has sapped the pool of high quality securities that can be used as collateral.
The Federal Reserve's quantitative easing program has sapped the pool of high quality securities that can be used as collateral.

New regulations are driving demand for high-quality bonds and stocks to post as collateral on derivatives trades. Sovereign wealth funds, with vast quantities of these securities, could profit — but there are risks involved.

As the dust settled after the 2008–’09 financial crisis, policymakers began thrashing out plans to make the global banking system more resilient. The ensuing raft of new regulations has radically changed the investment landscape. Banks’ new capital requirements, coupled with a clampdown on the derivatives markets, have dried up liquidity — making it more difficult for investors to find, develop, and finance deals.

Enter sovereign wealth funds. As at various stages of the financial crisis, when they rescued Western banks with multi-billion dollar investments, state-owned investors are helping to get capital flowing. They are increasingly moving into direct lending: Singapore’s GIC, for example, was among a group of investors that provided €1 billion ($1.46 billion) to Spanish real estate group Inmobiliaria Colonial in May 2014 through a syndicated loan. The Alaska Permanent Fund Corp., has entered riskier sectors, such as mezzanine debt, where banks now tread warily.

State investors are providing liquidity in more unorthodox ways, too. Under new European and U.S. regulations, market participants must post better-quality collateral — such as government bonds or blue-chip stocks — to execute derivatives trades. Sovereign wealth funds, which hold large amounts of such securities, are ready and willing to provide them to the market, either through their existing securities-lending programs or via newfangled strategies such as collateral transformation, which involves exchanging risky assets for safer securities that meet the new criteria. The potential profits, although they depend on the specific trade, are huge.

"There’s been enormous interest in the kind of securities sovereign wealth funds traditionally hold, such as government bonds," says Brian Leddy at Bank of New York Mellon Corp.’s Global Collateral Services department, which is working with several sovereign clients. "If funds are willing to make these securities available to the market as collateral, they have the potential to make considerable revenue."

Rising Demand

Collateral management strategies bring new hazards — both for sovereign funds, which are taking riskier assets onto their balance sheets, and the wider financial system. One early observer was Jeremy Stein, at the time a governor on the board of the U.S. Federal Reserve. He warned in February 2013 that regulators should keep a close eye on activities like collateral transformation because they create links between institutions that could be problematic in the next financial crisis.

For now, though, state investors are focused on the big returns they could make by getting their collateral out into the market. Demand is not expected to peak until later this year, when the deadline for compliance with new laws such as the European Market Infrastructure Regulation (EMIR) comes into force. But funds are already finding ways to profit.

Norges Bank Investment Management (NBIM), the arm of the central bank that manages the world’s biggest sovereign wealth fund, Norway’s $860 billion Government Pension Fund Global, has ramped up its securities lending program in recent months. And last year the New Zealand Superannuation Fund launched an in-house "Active Collateral Mandate" that seeks out opportunistic sources of yield, including the provision of liquidity in sectors from which banks have withdrawn because of regulatory pressures.

Mark Fennell, general manager, portfolio completion at NZ Super, heads up the active collateral team. He says via email that the fund is monitoring the rise in demand for teflon-plated securities: "Over time as more derivatives become or are required to be centrally cleared, the demand for high-quality, liquid securities to post will increase." Although NZ Super isn’t actively lending out collateral directly, Fennell says "there is a role for sovereign wealth funds in this space".

Liquidity Squeeze

The increased appetite for collateral can be traced back to mid-2009. As policymakers in Europe and the U.S. set about constructing a regulatory scaffold around the tottering financial system, they identified a shared source of concern — the opaque and complex derivatives market. If, as Warren Buffett suggested in 2002, derivatives are "financial weapons of mass destruction," then regulators’ task was to to disarm them.

Their solution, as enshrined in the two major pieces of post-crisis regulation — the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and EMIR, first passed in 2012 — was to require that investors clear over-the-counter derivatives trades through a central counterparty clearing house (CCP). The logic was simple: by guaranteeing the trade in the event of a default, the clearing house should prevent the kind of contagion that tore through the global markets in late-2008.

Under the new rules, market participants must post high-quality securities as collateral when using a clearing house. Classified as "financial end users" in regulatory parlance, sovereign wealth funds that trade derivatives for risk management reasons will be affected by the new regulation, and are moving to comply. Several funds are already taking advantage of so-called "collateral optimization" services being offered by custodian banks, which help them to more quickly and efficiently identify, segregate and mobilize securities that they can use as collateral on derivatives transactions.

"Sovereign wealth funds in particular are beginning to approach collateral as something that needs to be identified and managed across their entire portfolio," says Kelly Mathieson, global head of collateral management at JPMorgan Chase & Co. "We’ve seen strong interest in collateral optimization."

But while the new rules are creating compliance challenges they have also led to opportunities. State-owned investors tend to own large amounts of government bonds and blue-chip equities, so it’s not difficult for them to find the high-quality collateral they need to comply with the rules. Many other market participants, however, lack the necessary assets — and sovereign funds can help provide them even as banks become more wary of lending.

"Collateral Velocity"

Under the overhauled international regulatory framework known as Basel III, financial institutions must hold more liquid assets on their balance sheets as a buffer — and this has made them more reluctant to lend them out. The U.S. Federal Reserve’s massive bond buying program, dubbed quantitative easing, has further drained the market of collateral by removing U.S. Treasuries from active trading. A similar initiative by the European Central Bank (ECB) is set to resume next month, may have the same effect with triple-A rated government bonds in Europe.

The end result: a dearth of collateral just when the markets need it most. According to a July 2014 report from the ECB, the total additional collateral market participants will need to comply with the new derivatives regulation could reach €3 trillion ($4 trillion).

Manmohan Singh, a senior economist at the International Monetary Fund (IMF) in Washington D.C., says a lack of what he calls "collateral velocity" is exacerbating the problem; securities are sitting on bank balance sheets until maturity. Sovereign wealth funds can help by putting a portion of their combined $5 trillion in assets into market circulation.

"There’s enough collateral out there — there are about $70 trillion-worth of triple-A or double-A securities globally," says Singh. "But only a small fraction of that amount actually comes into the market. Sovereign wealth funds, and similar official sector conduits, can play a big part in satisfying that demand for collateral by circulating their liquid assets. And that’s a great opportunity for them to boost their returns, too."

Securities Lending

The potential boost in returns is a particularly attractive prospect at a time when bond yields have plunged to historic lows — Danish and Swedish sovereign bonds reached negative yields in early February 2015. Even some corporate bonds, such as those of Swiss confectionery giant Nestlé, have started trading at yields below zero since the beginning of this month.

In this environment, sovereign wealth funds can augment meager returns by lending their bonds out to the market. The simplest way for them to do this is through existing securities lending or repurchase-agreement (repo) programs. "If institutions are willing to participate in securities lending, collateral management can become a funded activity," says JPMorgan Chase’s Mathieson. "This a subject we spend a lot of time discussing with our clients: asset managers, insurance companies and sovereigns. By lending out their assets, these institutions could at the very least generate enough cash to meet their obligations and cover fees."

Many funds are currently expanding their lending programs exponentially. Take Norway. As of end-December 2012 NBIM lent out bonds worth 18.4 billion kroner ($3.3 billion) in connection with repurchase agreements; by December 31, 2013, the most recent date for which NBIM provided the relevant data, that figure had more than tripled to NOK 68 billion ($11.3 billion). Stock lending has also increased to NOK 22 billion as of September 2014, up from NOK 18 billion a year earlier.

Collateral Damage?

Some economists agree with former Fed governor Jeremy Stein that by lending securities as collateral, 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.

Singh at the IMF says derivatives regulation may create new systemic weaknesses. "Once you start putting 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," he says. "That makes the system more contagious."

Overall, though, Singh says he thinks increasing liquidity more than compensates for any increased risks. By increasing the free-flow of capital and circulating their high-quality securities, state-owned investors could bolster the resilience of the financial system.

Collateral management is a fast-developing industry. Sovereign wealth funds could generate major profits, but the overall effect on the financial system is open for debate. Such financial innovations, as always, bring with them a flammable mix of risk and opportunity.

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