An intriguing article on Bloomberg, published yesterday, throws light on the arcane world of collateral management.
Since the financial crisis there’s been a trend towards the greater collateralisation of financial market exposures. Fewer lenders are prepared to advance money on an unsecured basis, having seen how loans disappeared into the black hole of Lehman’s balance sheet.
However, Bloomberg reports that there’s a surprising difference between what banks post to their counterparties as collateral and what the counterparties post to banks in return. This is of great importance for the over-the-counter derivatives market, whose gross notional exposure dwarfs world GDP by a factor of around 10:1. In this enormous market 84% of collateral agreements are bilateral - in other words, they are negotiated on a case-by-case basis, rather than being set by any industry standard or government regulation.
Bloomberg gives the example of Goldman Sachs, apparently the best negotiator, which had received collateral worth 57% of notional exposure on its OTC derivatives contracts at the end of December 2009, while only posting 16% itself to its counterparties. That’s a difference worth US$110 billion, on which the bank can earn interest – a nice revenue stream if you can get it. For JP Morgan, collateral received also totalled 57% of notional exposures, while collateral posted represented 45%, a much smaller gap, while for Citigroup, the net balance was in the other direction by a margin of some US$11 billion.
Moving OTC derivatives onto exchanges would eliminate these balances, since banks’ exposures would no longer be to each other but to the exchange. Margin would be posted to the exchange as required by the overall mark-to-market value of each bank’s total positions. This would be a much safer system, since one of the major problems with the current setup is that funds posted as collateral to a dealer are not segregated, meaning that if a dealer fails, its counterparties will end up as unsecured creditors and face a likely loss of most of their assets. The likelihood of a chain reaction of failures is very high under such a scenario.
However, deciding what derivatives contracts are standardised enough to be exchange-traded is proving much harder than anticipated. Clearly, there are also vested interests that would lose out from a move to exchange trading.
What’s the relevance of this to exchange-traded products? While the collateralisation of exposures in ETFs is much more standardised under the UCITS regulatory framework (which almost all European ETFs follow) than in the over-the-counter derivatives market, how collateral is managed and the extent to which it is segregated, if at all, is crucial. Plus, with last year’s decline in credit risk we have seen the re-emergence of uncollateralised exchange-traded products. Bloomberg highlighting such large-scale collateral imbalances is a reminder of financial systemic risk –notwithstanding government backstops – that cannot be overlooked, something that should give investors pause for thought before incurring unsecured exposures.