Yngve Slyngstad is CEO of Norges Bank Investment
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
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
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.
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
Dodd-Frank Wall Street Reform and Consumer Protection Act of
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.
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
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
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.