How are you set up for collateral management?

Baughan

Baughan: Our collateral management is an integrated part of our wealth management platform as clients place assets with us for traditional wealth management activities.

We compare the exposure that our clients are taking against their assets and assess those assets on a daily basis through an integrated technology that calculates daily lending values.

This allows us to ensure we are being as efficient as possible in terms of the collateral requirements we place on our clients.

Being a relatively new business in Asia has allowed us to build an integrated technology platform for the input of trades, the setting up of our clients and the management of collateral – rather than having a fragmented platform.

With regard to margining for our FX products, we leverage Barclays investment bank’s technology (the margining and netting engine of Barclays prime services) to provide very competitive margin levels for our clients.

	Blanchard

Blanchard: J. P. Morgan provides custody services as a branch of business categorized as assets under management.

Where we can, we try to leverage the existing infrastructure on other lines of business within the great J.P. Morgan universe.

We endeavor in seeking ways to increase the profitability for our clients with their already current assets with us.

When we have a client who places assets with us, we assess the lending value on that particular asset type. Sometimes, a more focused credit review process would be needed.

What is the situation on the broker dealer side?
Boeding: Definitely, more focus has been placed on collateral management. The market has been more volatile and, as a result, it has changed the way in which we do our business. UBS has been more selective about how the investment bank uses the balance sheet. It is all about making sure that investors are comfortable with the mix of our business.

UBS has a legal entity that is the main international entity for most assets, and it has a US entity. Certain clients – such as a US pension fund or maybe a hedge fund with significant amounts of pension money invested in them – are required by law to interface with a US entity. The assets intended for lending in Asia are primarily with UBS AG in London. We have entities in Japan and Australia which hold some domestic assets. The strategy for UBS is a little bit unique in that we have a lot of liquidity, so we don’t need domestic liquidity in Australia or Japan. We have grouped all of our assets into UBS AG and we use them as collateral versus exchanges, versus counterparties, etc.

Are you anticipating market changes?

Boeding

Boeding: The market is undergoing many changes. If we had set ourselves up, based on what we thought would happen in 2009, we would be in a completely different place today. We have been forward-looking. For example, by establishing onshore platforms in Asia. This gives us a significant advantage.

Baughan: At Barclays, we have a project team that is looking ahead focussed on reviewing regulatory changes to ensure that we properly interpret and stay ahead of the changes relating to collateral management within the wealth management industry.

How does the Hong Kong Monetary Authority view these developments?
Lee: First of all, I’m not from the regulator side of the house. I’m on the financial infrastructure and operations side, essentially. One of my concerns is whether there are enough high-quality assets. There are two reasons for this concern.
One reason for this is that the Basel community of banking supervision has come up with the liquidity coverage ratio, in addition to the capital adequacy requirement. This liquidity coverage ratio is related to the crisis situation that may result from the sudden withdrawal of deposits from the banks.

In addition to the capital requirement, there has been increasing demand for those assets that can be easily liquidated in the market. Very often these refer to US treasuries, bunds and gilts. These are the high-quality assets.

Fortunately – or unfortunately at this point in time – we have got a lot of such assets because of quantitative easing and because the various governments efforts to finance their deficits.

Even in Hong Kong, where we do not have a fiscal deficit, we issue I-Bonds and government bonds to provide more high-quality assets to the market.

	Lee

Another reason for the increasing demand for high-quality assets is the collateral requirement of the central counterparty (CCP) clearing. Now we have all the standardized OTC derivatives being in the CCP clearing. In accordance with the Principles for Financial Market Infrastructures (PFMI) – as devised by the Committee on Payment and Settlement Systems (CPSS) and the International Organization of Securities Commissions (IOSCO) – the CCP should maintain sufficient liquid resources to cover the default of the two largest participant and its affiliates if the CCP is involved in activities with a more complex risk profile or systemically important in multiple jurisdictions.

It is not easy for any CCP to come up with a liquidity provision to cover the two largest participants. It may be a little easier for managing credit risk but it is even more difficult for managing liquidity risk, because you need to ensure that all the trade on that particular day can be settled and the demand for liquidity can be in gross terms in some cases, instead of just in net terms. There is a need to have to money to buy the stocks before you can deliver the stocks to the other counterparties in the CCP. That is the reason why we have this increasing collateral requirement.

In addition to the CCP and the margin requirement for the OTC derivatives comes the tricky issue of FX swaps. An FX swap is actually one form of collateralized lending. The debate is interesting. There is no requirement to go through the CCP because FX swap is no different from collateralized lending.

Also, for the FX swap you have to deliver not just the difference but the principal amount of the two currencies involved on the settlement date. Consequently, the chance of a systemically important default should be less than in the case of the other derivatives which just settle the difference.

Moreover, the principal risk arising from settlement of FX swap is largely eliminated through various forms of payment versus payment (PvP) settlement arrangements, including the arrangement currently offered by CLS Bank International.

There may still be margin requirement for FX swap that is settled bilaterally. For instance, the FX market size of the Hong Kong dollar against the US dollar together with the FX market size of the offshore renminbi against the US dollar can easily exceed US$100 billion daily and a large proportion of this can be related to swap transactions. A margin requirement involving only a small percentage of these FX swap transactions would be rather substantial.

FX forwards are likely to be more volatile and risky. However, we still have not found a way to match the relevant swap and spot transactions which constitute a forward.

So it is likely that the margin requirement for FX swap, if any, will be across the board for all FX swaps instead of just those swaps related to a forward transaction.

Greaves

Greaves: This raises a question: Since CCPs are not necessarily collateral management specialists themselves, how are they managing participants’ collateral? For example, asset owners may start to ask themselves the question “How safe is my collateral with the CCP?”, especially during market turmoil when major counterparty default situations could arise.

Also, there is no uniformity across the many CCPs. Participants will need to understand each CCP, and perhaps transact where their requirements are satisfied.

Lee: There are rules governing the uses of the collateral at the disposal of the CCP and there is a waterfall on the sequence of how the assets with the CCP can be used in time of a crisis. There are clear distinctions between default fund contribution, initial margin and variable margin regarding how they can be used in time of a crisis. The collateral can be in form of cash (a very common form of collateral in Asia) and/or holdings in the ICSD such as Euroclear, Clearstream or in some local CSDs for bonds, equities and other financial assets.

Greaves: BNY Mellon, as a service provider to many of the largest financial institutions in the world, has touch points with clients in a variety of different ways. BNY Mellon recently completed a survey of insurance companies in the US, which was an update of a survey from last year. The results provide an interesting insight into how US insurance companies are coping with the change in the regulatory framework and how they view their own progress towards being prepared. Although the majority of institutions acknowledge the need to change how they manage collateral, there are still a number of institutions that believe that no change is necessary for their business model.

We are currently developing a collateral optimizer-aggregator which helps clients to optimize the allocation of their collateral across their entire book. This is an important area where we see ourselves adding value to our clients as a service provider, helping them to meet regulatory challenges by providing solutions that help reduce their cost and increase their efficiency. It is a challenging environment for everyone, but we also see it as an opportunity.

Boeding: There can be quite a few economies of scale if you partner with someone who is connected to people on the other side. So if BNY Mellon has relationships with all the major exchanges, etc, I can put all of my collateral into them and making sure that its going to where it should be going, rather than managing it myself or managing it across a variety of institutions, rather than collateral moving from A to Z and A to Z and all the costs related to that.