The Collateral Squeeze: OTC and Derivatives
After Lehman Brothers’ bankruptcy on September 15, 2008, the pressures surrounding funding which had affected multiple financial firms since early 2007 reached critical mass. This incident compelled all financial institutions to take notice of their collateral positions and review their margin call processes.
In 2003 Warren Buffet called derivatives “weapons of mass destruction”. Was he right in doing so?
In financial terms Collateral is a property or other asset that a borrower offers as a way for a lender to secure the loan. Collateral management is the process that among other things helps to reduce counter party credit exposures. It is commonly used with over-the-counter (OTC) derivatives like swaps and options. If two parties agree to enter into a collateral agreement this is what happens.
Numerous regulations centred on reducing counterparty risk were released and updated as a result of the uncollateralised derivative activity. Since then, regulations have ensured that all derivatives transactions have the use of collateral in an attempt to alleviate the chance of these investment banks, once deemed too big to fail, would not fail again.
In the modern financial industry, collateral is mostly used in OTC trades. Collateral management is now a complex process with multiple inter-related functions across various parties. Even large pensions and sovereign wealth funds, which typically hold high levels of quality securities, have begun looking into opportunities within collateral transformation to earn fees.
All collateral must meet incredibly strict and stringent eligibility criteria; this was the underpinning idea behind linking derivatives with collateral – if the collateral is of good quality, so too would the underlying derivative transaction be. Sounds pretty safe right? However, the industry then began to fear that a “collateral squeeze” would occur where there is a surplus of demand in collateral, pushing the price up and then making derivatives less profitable and consequently, less attractive. They were almost right, demand for collateral is greater than it has ever been before and yet the predicted dip in derivatives demand has not yet occurred.
In conclusion – as of yet the predicted “collateral Squeeze” hasn’t really materialised. You will never be able to implement a regulation that prevents institutions from taking risks onto their balance sheet to increase their equity return, with sell-side firms favouring more exotic trades.
With the new regulations in place, firms are now expected to provide open information regarding their margin call processes. However, the full extent of this regulatory update is not due to become public knowledge until 2019/2020 with some firms having missed the deadlines to share their margin calls. With this in mind we could potentially be on the verge of another crash once all of this sharing of margin call becomes mandatory.
Will the “collateral squeeze” ever actually materialise? Only time will tell...
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