Historically, collateral management and securities lending have been treated as two separate activities but recent market forces have brought them closer together.
One such dynamic is regulation mandating the use of collateral, which was introduced in response to the global financial crisis of 2008. Several areas of this global reform focused on collateral: for example, mandatory variation margin requirements and implementing rules around initial margin for over-the-counter (OTC) derivatives transactions.
A growing number of firms and products have found themselves in scope of the rules since they went live in a phased approach over the last five years. The use of derivatives in Asia has grown over the same period, and so in turn has the demand for collateral management services.
What we found, particularly in Asia Pacific (APAC), was that we did not have many clients caught up in the first few phases of mandatory regulation – previously many of our clients trading OTC transactions didn’t have to collateralise them
Natalie Floate, head of market and financing services
“What we found, particularly in Asia Pacific (APAC), was that we did not have many clients caught up in the first few phases of mandatory regulation – previously many of our clients trading OTC transactions didn’t have to collateralise them,” says Natalie Floate, head of market and financing services, APAC at BNP Paribas Securities Services. “Then clients were in-scope for variation margin and went live quickly and efficiently using cash as collateral. Cash could be deployed, managed, settled and reused quite easily, the operational impact was low, and it meant they could tick the box and be compliant with the regulations. This was understandable as the regulations went beyond collateral into trade reporting and other areas – it was quite impactful for many clients from front to back office.”
However, for some clients using cash collateral can create a drag on portfolio performance, especially in those portfolios that are focused on capital growth via assets with little cash allocation. In addition, as inflation and interest rates are expected to increase in the coming years, demand for cash collateral will be impacted and no longer necessarily be the ‘easy’ default option. Tight markets are making fund managers extract value from across all elements of their portfolios.
“There will be other opportunities to invest that cash into high yielding instruments or other investments,” notes David James Brown, APAC head of collateral services at BNP Paribas Securities Services. “And as such more desire to deploy non-cash collateral will ensue.”
This is where securities lending can come into play – the diversification of collateral types that can be used in transactions has seen non-cash options come to the fore including equity, corporate and government fixed income solutions.
Activity in APAC was, for a time, driven by European and American banks, but regional institutions have increasingly embraced the collateral process and developed it to become a core competency. The market has seen increasing levels of demand for issuers from South Korea and Taiwan, both in terms of equity and corporate bonds.
“In APAC, most of our trading desks spend the majority of their time focused on local assets from a borrowing and lending perspective,” says Floate. “We have a mixture of mature and evolving markets in APAC which presents the best of both opportunities.”
Rising levels of activity have also influenced the use of another type of high quality asset - government bonds. Internal asset liability management has been the primary driver of demand, with treasury teams looking at balance sheet management and funding needs, raising liquidity via repo trades to access cash.
Regulatory requirements around the minimum quality of collateral types have brought additional attention to some assets; in particular, Japanese government bonds or JGBs which dominate Asian fixed income collateral types. Interest in other Asian sovereigns is increasing such as Australian or Singapore government securities, which are also highly rated or considered as high quality.
“However, high quality liquid assets are comparatively expensive, hence why flexibility around collateral is essential,” says Floate. “This is where the role of an agent or principal lender and collateral manager is key. We have the distribution reach and flexibility to guide our clients. For example, they might not see demand from other firms for Singapore government bonds but we have counterparties on our side that are looking for them.”
Clients are looking for more than just execution of their trading strategies, she adds.
“They want us to help connect them with other counterparties or providers, and advise them about what is happening in the market and trades they could be doing.”
Local knowledge, global infrastructure
“More clients are asking which non-cash options are available to them – and we have seen market requirements change,” confirms Brown. “Our Asian client base is growing in knowledge and sophistication alongside local markets developing more when it comes to collateral. Collateral management is a global process that also requires local knowledge.”
Historically more common in Europe and the US, the use of a triparty agent has recently been increasing in APAC. New eligible types of collateral, greater connectivity, automation, time zone coverage and demand for better visibility into portfolio management are all factors supporting the use of a triparty agent for collateral management. Put simply, triparty agents support clients with selection, optimisation, allocation of the collateral, valuation and any other corporate action or event processing.
“It all comes down to one thing: clients want data on their asset’s performance, settlement information, and risk qualifiers quickly and efficiently,” says Floate. “They can then turn this data into knowledge in terms of their liquidity needs.”
Client demand for straight through processing and automation – in many instances on an international scale – means that having the infrastructure of the global custodian bank is key to support clients ‘around the clock’.
“If you are based in Asia Pacific and you have counterparties that deliver US collateral assets, you may need support to manage the process effectively,” says Brown. “When the US bond market nears the close, it is early APAC morning on the following day. You increasingly need to have the international network to support collateral activity because a lot of counterparties will want to move global assets.”
There are several key areas where having the support of a global triparty collateral management team can be valuable. The first consideration is sourcing – creating eligible collateral pools which can involve transformation in order to get access to the right type of assets. This is followed by selection, which is more about utilising collateral in the most cost effective and efficient way, analysing mobility factors.
“That is where the processes all start to interlink,” says Brown. “You will need a mechanism to source, select and then settle the assets. Increasingly this means your collateral operations will need to be global or have the support of a global service provider.”
Next is the servicing element. “Common challenges include substitution, corporate actions and coupon events,” warns Brown. “If you are going to move collateral internationally, you need to have robust processes to manage post-settlement considerations, and obviously collateral assets can change in rating or price, so you will need to have valuation and credit risk management processes in place.”
Recently, agent lenders have been expanding acceptable forms of collateral beyond equities and bonds into new non-cash alternatives such as ETFs although this has not yet stretched into newer assets such as crypto. In addition to these changes, new considerations such as ESG have emerged - a topic that is gaining traction in APAC driven by regulatory, social and economic mandates.
Proxy voting, for instance, has been a fundamental topic when clients talk about ESG, especially in Australia.
“When it comes to securities lending, beneficial owners such as superannuation funds want to be active shareholders and to have comfort in the end-to-end management of loans, including any recall that may be required to facilitate their vote casting at general meetings,” says Floate.
ESG objectives tend to be set at the portfolio or investment mandate level by clients, and then filtered down to individual activities like collateral management and securities lending.
“This is an area where we expect to see further developments,” predicts Floate. “As a global custodian, we wear various hats for many of our clients. If we have that full view of their portfolios from custody to collateral manager, we have the ability to optimise their investments throughout the cycle end-to-end.”
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