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