No such thing as ‘one size fits all’
20 February 2018
As the introduction of regulation continues to affect how each firm manages their capital, financing and liquidity decisions, the need for control remains paramount. Stephen Michael and O’Delle Burke of J.P. Morgan explain
Image: Shutterstock
The view from Asia Pacific
When it comes to collateral, control is paramount, but how you define control depends upon your role. For example, borrowers want to be able to define optimal collateral allocation to address specific binding constraints, while lenders want access to more real-time reconciliation and automated processing of collateral schedules.
These were some of the takeaways from a series of client roundtables hosted recently by J.P. Morgan in Hong Kong and Sydney, where collateral counterparts came together to discuss the local, regional and global factors influencing their financing and collateral decisions.
For broker dealers, these factors include the potential for more balance sheet decentralisation, which could result in more financing being done directly by Asia Pacific entities. Lenders, meanwhile, saw the value of on-loan assets (and related collateral) rise during 2017, driven by underlying market strength. While noting that significant work has been done to manage against capital requirements and deploy assets more efficiently, participants agree there’s still more opportunity as markets continue to evolve.
Our discussions converged on three key themes.
A flexible toolkit to meet individual firm requirements
Each institution is managing to its own unique mix of legal entities, regulatory oversight and binding constraints related to capital. Broker dealers continue to focus on optimising balance sheet, and most are looking to define collateral allocation parameters and develop their own internal algorithms. Being able to make optimisation recommendations to a collateral agent is a critical factor in adhering to capital requirements.
Borrowers and lenders also seek flexibility and agility in managing collateral schedules. For them, online tools support speed of execution and provide welcome transparency: collateral providers can employ instant queries to learn which counterparties can accept their collateral, while collateral receivers can monitor and adjust their eligibility criteria at a granular level based on their firm’s parameters.
Access to markets and structures to manage financing
and liquidity
For institutions operating in Asia, regulatory change has heightened the focus on being able to fund their activities locally and efficiently. In Taiwan and Korea, a successful framework has been developed that lets broker dealers mobilise once ‘trapped’ assets, using tri-party structures to deploy them onshore. Options such as total return swaps, for example, the use of derivative trades for securities financing, could be used to derive additional balance sheet and capital benefits. Other markets such as the Philippines and Indonesia are exploring the use of tri-party structures to unlock liquidity.
New markets continue to spark interest, particularly China (with A-shares due to join the MSCI) by mid-2018). Banks’ underlying clients, particularly hedge funds, are eager to hedge and want access to single stock swaps. Given the level of interest in China, borrowers agreed that having a China strategy now is essential, even though activity is likely to ramp up over a period of time given the structural challenges that will need to be addressed.
Innovative uses for tri-party, in particular pledge structures for collateral, were an active topic of discussion. Originally intended to manage haircuts or margin, pledge structures could be used for the entire loan exposure amount following the successful use of pledge models in tri-party for segregated initial margin. Pledge structure, which leverages the existing market infrastructure, could be quicker to market than other emerging options, such as central counterparty (CCP) structures.
Broker dealers believe that pledge structures offer the potential for a reduction in the cost of capital, while lenders also see possible benefits that could include increases in spread, haircut and simplified reporting. However, one challenge for lenders will be explaining the impact of moving to a pledge structure and obtaining the consent of underlying beneficial owners. A standardised principal relationship agreement (the Global Master Securities Lending Agreement) and security agreement supporting pledge structures is expected soon from the International Securities Lending Association (ISLA).
The ability to support potential changes in booking models
Previously mentioned regulatory and funding requirements, are also driving structural changes for broker dealers. Most have seen better integration across desks over the last few years, as financing is viewed more holistically than in the past. And, while many decisions related to capital allocation, financing or trading are still made centrally from New York or London, some of the firms represented at the roundtables are evaluating their booking models. Roundtable participants discussed a ‘hub and spokes’ model that could create greater regional autonomy, and noted that local support for increased collateral or financing activities would become ever more important. However, a ‘one size fits all’ model is unlikely, particularly given impending geopolitical changes such as Brexit.
Generally, participants seemed optimistic about 2018 although some broker dealers noted that the recent growth seen in collateral balances does not necessarily equate with balance sheet growth. In some cases, regional desks are benefitting from additional allocation of relatively flat balance sheets globally, due to higher yielding markets in Asia Pacific. Lenders feel that balance growth has been underpinned by market strength, but expect to see more borrows to hedge long positions in case of market turbulence.
We expect these themes to be important for some time to come, as the ongoing introduction of regulation in different markets is likely to have a continuing impact on how each firm manages their capital, financing and liquidity decisions. Given that, the need for control, with access to a variety of button and levers that can be pushed to create bespoke solutions, remains paramount.
When it comes to collateral, control is paramount, but how you define control depends upon your role. For example, borrowers want to be able to define optimal collateral allocation to address specific binding constraints, while lenders want access to more real-time reconciliation and automated processing of collateral schedules.
These were some of the takeaways from a series of client roundtables hosted recently by J.P. Morgan in Hong Kong and Sydney, where collateral counterparts came together to discuss the local, regional and global factors influencing their financing and collateral decisions.
For broker dealers, these factors include the potential for more balance sheet decentralisation, which could result in more financing being done directly by Asia Pacific entities. Lenders, meanwhile, saw the value of on-loan assets (and related collateral) rise during 2017, driven by underlying market strength. While noting that significant work has been done to manage against capital requirements and deploy assets more efficiently, participants agree there’s still more opportunity as markets continue to evolve.
Our discussions converged on three key themes.
A flexible toolkit to meet individual firm requirements
Each institution is managing to its own unique mix of legal entities, regulatory oversight and binding constraints related to capital. Broker dealers continue to focus on optimising balance sheet, and most are looking to define collateral allocation parameters and develop their own internal algorithms. Being able to make optimisation recommendations to a collateral agent is a critical factor in adhering to capital requirements.
Borrowers and lenders also seek flexibility and agility in managing collateral schedules. For them, online tools support speed of execution and provide welcome transparency: collateral providers can employ instant queries to learn which counterparties can accept their collateral, while collateral receivers can monitor and adjust their eligibility criteria at a granular level based on their firm’s parameters.
Access to markets and structures to manage financing
and liquidity
For institutions operating in Asia, regulatory change has heightened the focus on being able to fund their activities locally and efficiently. In Taiwan and Korea, a successful framework has been developed that lets broker dealers mobilise once ‘trapped’ assets, using tri-party structures to deploy them onshore. Options such as total return swaps, for example, the use of derivative trades for securities financing, could be used to derive additional balance sheet and capital benefits. Other markets such as the Philippines and Indonesia are exploring the use of tri-party structures to unlock liquidity.
New markets continue to spark interest, particularly China (with A-shares due to join the MSCI) by mid-2018). Banks’ underlying clients, particularly hedge funds, are eager to hedge and want access to single stock swaps. Given the level of interest in China, borrowers agreed that having a China strategy now is essential, even though activity is likely to ramp up over a period of time given the structural challenges that will need to be addressed.
Innovative uses for tri-party, in particular pledge structures for collateral, were an active topic of discussion. Originally intended to manage haircuts or margin, pledge structures could be used for the entire loan exposure amount following the successful use of pledge models in tri-party for segregated initial margin. Pledge structure, which leverages the existing market infrastructure, could be quicker to market than other emerging options, such as central counterparty (CCP) structures.
Broker dealers believe that pledge structures offer the potential for a reduction in the cost of capital, while lenders also see possible benefits that could include increases in spread, haircut and simplified reporting. However, one challenge for lenders will be explaining the impact of moving to a pledge structure and obtaining the consent of underlying beneficial owners. A standardised principal relationship agreement (the Global Master Securities Lending Agreement) and security agreement supporting pledge structures is expected soon from the International Securities Lending Association (ISLA).
The ability to support potential changes in booking models
Previously mentioned regulatory and funding requirements, are also driving structural changes for broker dealers. Most have seen better integration across desks over the last few years, as financing is viewed more holistically than in the past. And, while many decisions related to capital allocation, financing or trading are still made centrally from New York or London, some of the firms represented at the roundtables are evaluating their booking models. Roundtable participants discussed a ‘hub and spokes’ model that could create greater regional autonomy, and noted that local support for increased collateral or financing activities would become ever more important. However, a ‘one size fits all’ model is unlikely, particularly given impending geopolitical changes such as Brexit.
Generally, participants seemed optimistic about 2018 although some broker dealers noted that the recent growth seen in collateral balances does not necessarily equate with balance sheet growth. In some cases, regional desks are benefitting from additional allocation of relatively flat balance sheets globally, due to higher yielding markets in Asia Pacific. Lenders feel that balance growth has been underpinned by market strength, but expect to see more borrows to hedge long positions in case of market turbulence.
We expect these themes to be important for some time to come, as the ongoing introduction of regulation in different markets is likely to have a continuing impact on how each firm manages their capital, financing and liquidity decisions. Given that, the need for control, with access to a variety of button and levers that can be pushed to create bespoke solutions, remains paramount.
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