Post-crisis regulatory reforms designed to reduce risk in the financial markets have spurred a major increase in demand for eligible collateral, notably among banks, asset managers and owners. </p> Industry estimates vary about how much additional collateral will be required as the rollout of new regulations continues to ratchet up demand. But a study by Oliver Wyman and Morgan Stanley has claimed the market will need to find an extra US$1.4 trillion by 2018. Sourcing this collateral is going to be an enormous task across the market. </p> But one promising source of cash collateral is the corporate sector. For an increasing number of corporates, the repo market is emerging as a popular way of raising non-cash assets. </p> While some corporates might look to use the repo markets to switch cash for securities to support margin calls as OTC derivatives move to central clearing, many others simply see repo as an alternative to time deposits at banks, the traditional home for their short-term cash. “We see a growing number of non-traditional cash providers, amongst others corporates, willing to use Euroclear Bank as tri-party collateral repo agent,” says Olivier Grimonpont, head of collateral services at Euroclear. “Also, following the financial crisis, with low long-term interest rates and growing concerns around the risks associated with banks’ funding, several corporates now go direct to the capital markets rather than through the traditional bank loans.”</p> A market transformed</strong></p> Much of the post-crisis upsurge in collateral demand stems from OTC derivatives reforms – which require high-quality collateral (broadly speaking, cash or government bonds) to be posted as margin at central counterparties by derivatives users including asset managers, insurance firms and pension funds – and Basel III, the new capital and liquidity framework that forces banks to increase their level of high-quality liquid assets, as defined by the Basel Committee.</p> The repo market – where banks have typically looked to meet their short-term funding requirements by lending out securities for cash via repurchase or ‘repo’ transactions – is now undergoing a transformation to meet the more disparate needs of a wider range of participants. </p> Pascal Morosini, head of global securities financing sales and relationship management at Clearstream, explains the appeal of the repo markets to corporates: “Corporates have started to appreciate the increased risk of bank bail-in and that unsecured deposits, whilst convenient, do not offer the most secure investment option,” he says. “Unlike time deposits, tri-party repos are backed with specific collateral which fully secures the re-invested cash. As a result, a repo affords greater protection for the corporate treasurer from the default of its banking partner, in particular if the collateral management is outsourced to an independent tri-party agent.”</p> Non-banks tend to access the repo market via the services of tri-party agents, as this removes much of the administrative burden of repo transactions, such as day-to-day valuations and the selection and substitution of collateral assets. In short, tri-party repo transactions give corporate treasurers more control, as deals can be customised to their precise risk appetite and cash flows. “Concerns around taking certain sovereign debt as collateral, for example, can easily be sidestepped by requiring the use of highly-rated corporate bonds or major index equities as collateral alternatives, or a combination of different asset classes,” says Euroclear’s Grimonpont.</p> White knights</strong></p> The growing interest of corporates in repo as an alternative to bank deposits, commercial paper or certificates of deposits is injecting more liquidity into a market once confined to central banks, money market funds, commercial and investment banks. “Liquidity from this new source is already alleviating a perceived scarcity of collateral,” says Grimonpont. “Corporates should not be seen as ‘white knights’ equipped to single-handedly save the financial world, but they will certainly contribute to its new equilibrium.”</p> Considering the pressure banks are under to diversify their sources of funding and to prove they have access to stable, long-term cash, many have become eager to undertake repos to access corporate holdings. Basel III may have increased banks appetite for collateral, but it has diminished their returns from the repo market business, causing some to curtail their participation levels. Clearstream’s Morosini says the increased presence of corporates has the capacity to mitigate liquidity concerns.</p> “Banks need to continue to educate the corporates on the changes that have been imposed on them and the impact this has on capital and the costs of an unsecured transaction versus a secured transaction to a corporate,” he explains. “Going forward, pricing transparency as well as relationships will become more important. For this reason, it is imperative that corporates understand what products their banks can offer them based upon the liquidity and yield parameters they stipulate and implement streamlined workflows around this.”</p> If safety and liquidity are the foremost priorities of corporates when engaging with the repo markets, yield too is a factor, even though it can be hard to find in a low-to-negative interest rate environment. “Banks are looking to maximise the use of available inventory at a time when balance sheets are constrained and there is a greater focus on reducing leverage and cost of capital,” says Morosini. “As a result of this trade-off opportunity, banks and their corporate clients can pro-actively negotiate terms that give corporates the option of additional yield – most likely versus term funding – as well as ensuring consistent access to liquidity.”</p> Threshold threat</strong></p> If corporates see repo today as part of their cash investment strategy, they may soon see it also as a way of meeting margin obligations. Many European firms, for example, face the prospect of posting collateral to support centrally cleared swaps from Q3 2016.</p> Under the European Market Infrastructure Regulation (EMIR), corporates are subject to different requirements depending on whether they meet clearing thresholds. For example, if its trading activity exceeds €3 billion in gross notional value for interest rate and FX, a corporate will be regarded as an non-financial counterparty (NFC) – and therefore subject to additional reporting requirements, the clearing obligation, bilateral margin requirements, and stricter operational rules. However, transactions designed to reduce risk to commercial or treasury financing activity do not count towards the threshold.</p> “The regulations prescribe different entity classifications and this allows a corporate to determine when and how they are impacted. From September 2016, these corporates will also be obliged to provide trading counterparties with variation margin to offset the risks associated with their derivative contracts,” adds Morosini.</p> “Furthermore, between 2016 and 2019 they also will be required to lodge initial margin. Tri-party repo and collateral management is at the forefront of their thinking, as it presents a safe and secure option to manage the risks and opportunities that they now face.”</p>