Liquidity and Collateral: getting the blood to flow again

Cash is a dirty word for some cultures, but not for financial services, on the contrary. But I am not talking about the old images of the stingy bankers holding on to their $ bills or about Scrooge McDuck.

Banks, custodians, CCPs, CSDs and exchanges are the financial institutions that enable the exchange of cash for securities, the movement of cash between bank accounts, the securitization of cash, the transformation of cash into collateral. Without these markets players entire economies cannot function: they are the safe and resilient pipes and the pipe operators that enable companies to be financed, investors to invest, prices to be made, etc.

The difference between Liquidity and Collateral is that Liquidity is the money used for overnight funding during the settlement, is the money that is in the treasury of a corporate or a bank to finance short term money needs, whereas collateral is usually a security that is given as a pledge to guarantee that one has enough money for a transaction, to bear the risk of a transaction, to be able to exchange it against cash if need be in a Repo transaction, at a CCP or a broker. Collateral was historically required to be of very high quality: high grade government bonds, sovereign or agencies. However these have become extremely rare as collateral is required for many more purposes now than ever to guarantee the stability and safety of every transaction. Banks have very little of it because keeping collateral on one’s balance sheet is extremely expensive from a regulatory stand-point. But if nobody oils the pipes, they cannot work anymore. 

We have seen in our recent European Post-Trade Infrastructure Evolution: Switching Gears for the Long Run report that where collateral really needed to be optimized today was before settlement, and across assets and for listed and OTC assets. Until today this was not possible as assets were very rarely optimized between equities and fixed income, and that un-cleared derivatives, never making it to a CCP, where always excluded from cross-margining or netting opportunities offered, except after the settlement at the ICSDs but this is sometimes too late in the trade value chain.

This is changing though as Repo platforms and ICSDs have realized they needed to step in to enhance the fluidity of the financial blood. Today we are seeing a myriad of new initiatives that aim at creating some sort of “Collateral Exchange” whereby securities can be upgraded or transformed into more attractive collateral, or even exchanged against another one that is more useful at the time. Elixium with Tradition and Euroclear, Euronext’s Collateral Exchange, BoNY’s DBVX, 360T with Clearstream, the list is already long and is bound to get longer. We are excited to see how these new solutions will pan out and will be watching this space very closely. More in our two upcoming Celent reports about respectively collateral management and post trade technology.

Cash safe haven for investors and corporates?

I was writing a piece of research on the ABS and Repo markets in Europe this Summer and stumbled onto an innovative product offered by MTS and Newedge, Agency Cash Management (ACM) and thought, “wow, this is really innovative and this is what the market needs”. ACM does provide a tri-partite Repo system whereby investors, in an electronic auction regulated platform, enter into a repo trade with banks via tri-partite agents, exchanging their extra cash against good collateral, lending securely and concurrently earning a fee for it. This is really spot on to me as many investors nowadays have extra cash that they do not know where to invest, that they do not want to leave on a bank deposit account because they don’t trust their bank’s creditworthiness anymore, or that they do not want to invest in a Money Market Mutual Fund because they got burnt during the crisis. However they do want to get some return for lending that cash to someone. ACM does exactly that. This is theory obviously, in practice going after all the potentially cash-rich investors, getting them to sign tri-partite contracts with tri-partite agents is going to take some time. Also, in the good quality collateral constrained environment that we are in, banks may not have all this good collateral to offer against these piles of cash, but then again they may find a way to transform bad collateral in good one, this is what banks (and shadow banks and shadow banking products) excel at doing. EurexRepo and Eurex Clearing are working on a similar offering to ACM that should launch in 4Q2012. The model is created to offer banks that are current GC Pooling clients a facility to enter into a Repo trade with their coporate clients, in an electronic and centrally cleared environment. Cleastream is the tri-partite agent here and can take care of the collateral management, which is becoming ever more useful. Practically it may be as hard to get corporates as to get investors to sign tri-partite repo agent contracts, but the theory holds: cash-rich corporates, like investors, do not want to leave their cash on a deposit account, want a secured way to place their cash and want a fee for it. We see both as really innovative products that respond to real market needs: watch this space.