Collateral supply, demand and mobility
30 September 2024
Graham Gooden, EMEA head of triparty collateral management at J.P. Morgan, outlines the five core themes the firm and its partners are focused on in H2 2024 and 2025
Image: stock.adobe.com/Bernice
Collateral supply, demand and mobility are all factors influencing the expanding and ever-evolving global collateral ecosystem, now estimated to be over US$25 trillion in size.
The expected Basel III Endgame rules coming into effect from 2025-26 and the long tail of segregated initial margin implementation are two drivers of increased demand, while the growth of new collateral markets and digital innovation represent examples of how supply and mobility of collateral is expanding in parallel.
Capital efficient structures
Given the potential impact of Basel III Endgame, it comes as no surprise that capital efficiency continues to be near the top of the in-tray for many sell side firms. There is no one-size-fits-all, and approaches should be seen as a suite of options, deployable to target different challenges, depending upon the relative and dynamic inputs and constraints of the individual firms.
Key areas of focus that have been leading our discussions include pledge, transfer title pledge-back, and securities financing-focused central counterparties (CCPs).
Exchanging collateral under a pledge arrangement for securities finance has been established for a number of years, with the market coalescing around standardised documentation and a standardised operational model. Pledge has worked well, mainly for non-US banks with increasing uptake expected as we move towards 2025 and beyond.
Driven by the differing client needs such as those of US-regulated banks, an augmented approach is ‘transfer title pledge-back’, where collateral is transferred under full title, with either the margin or full collateralised amount, pledged back to the collateral provider — the aim being to help reduce the cost of capital associated with the unsecured exposure caused by over-collateralisation of the margin.
Reduced capital footprint is a key benefit of transacting through a CCP, and we are seeing strong collaboration across the collateral ecosystem in both securities lending and repo on both sides of the pond. Combining new securities finance cleared models with the established automation and scale of existing industry solutions like triparty, offers the opportunity of market adoption at scale within tangible timeframes.
Intraday liquidity
Traditionally, liquidity can take many forms, at its simplest as credit lines, excess cash, or security buffers (eg longboxes in triparty parlance). But more recently, we have been able to help facilitate more complex approaches to structuring and sourcing liquidity.
Liquidity is not cost-free, attracting commitment fees, direct usage fees, or the indirect cost of forgoing the benefit of a fully funded inventory. As settlement cycles shorten, technological advancements increasingly enable real-time, firm-wide monitoring, as does the monetisation of liquidity intraday, with the cost to use liquidity in some cases starting to be applied by the minute.
Repo has long been a key pillar of liquidity management with sell side firms raising cash to the tenor and currency as necessary, providing a yield to the buy side in return. As liquidity requirements gravitate to intraday, so too has the need for intraday repo, which as a structured trade can be more cost efficient than incurring liquidity costs at a custodian, triparty agent, or infrastructure provider.
Intraday repo through blockchain has been one area of focus and has been a reality for a number of years. The same goes for the ability to transact intraday repo through traditional triparty — providing an additional source of liquidity for dealers and yield enhancement for cash providers.
From a triparty programme perspective, we have seen a number of alternative approaches to source additional securities collateral that can be used to provide liquidity for allocation, substitution, and optimisation strategies throughout the day. Some strategies include sweeping excess collateral to be made available intraday, others include more structured trades such as high-quality liquid asset (HQLA) contingent funding trades.
Collateral expansion — emerging markets
Expanding collateral supply can take a number of forms, with expansion of existing product scope to new geographical locations perhaps the most obvious but not always the most straightforward. Local regulation, legal requirements, and tax or market settlement processes can necessitate bespoke or innovative solutions.
As emerging markets build out the full breadth of financial services infrastructure, use of issued securities as collateral is often not at the forefront of regulator or legal frameworks, however important a post-trade activity it has become.
As a collateral practitioner, adding incremental markets can take time to undertake due diligence and understand local market nuances to augment standard international product offerings to the local market requirements. Led by success in the Asia Pacific region in recent years, the collateral ecosystem has developed a good cadence for adapting to new markets like South Korea and Taiwan, and we see a promising pipeline of new collateral markets including Saudi Arabia, South Africa, Indonesia, and Malaysia.
Simply adding a new market does not necessarily mean adoption is immediate and substantial. Building that network of providers and receivers comfortable with documentation and operational processes can take time.
Mexico is a market we have long served, and after steady initial growth, we are anticipating strong uplift over the next year there. While initial margin collateral requirements under the Uncleared Margin Rules (UMR) have been live across major jurisdictions since 2016, mandatory posting of regulatory initial margin is effective in Mexico from 31 December 2024 and is proving a catalyst for triparty adoption, initially to satisfy for UMR, but also a stepping stone for other types of collateral management and securities financing activity.
Many local firms are excited to set up triparty, not only for their initial margin requirements, but as it will be a bridge to expand financing opportunities such as repo with Mexican-issued securities and pesos.
Collateral expansion — digital assets
In addition to increased operational efficiency and collateral velocity, part of the appeal of digital assets is to improve liquidity by increasing fractional ownership through asset division or transfer of baskets through aggregation, making assets more accessible to a wider range of investors.
Tokenisation also offers the opportunity to expand the supply of collateral, ranging from tokenisation of physical assets, individual assets, or a pool of securities. Once assets are tokenised, ownership can be transferred across the blockchain at speed, scale, and transparency throughout the chain.
Real world examples of how this can expand the scope of collateral markets include money market funds (MMFs) — long regarded as a great source of credit but with limited transferability between counterparties limiting their utility as a form of collateral. Tokenised MMFs retain the same credit qualities but are freely transferable and are now being used as initial margin, expanding the potential supply of available collateral for the broader ecosystem.
Similar to the issuance of natively digital assets, which we have seen through a number of nascent private blockchain platforms, a key factor for greater adoption hinges on whether digital assets can be mobilised once acquired and whether they can be used as collateral or be financed. Therefore connecting private blockchains issuing digital assets, with the full suite of triparty functionality and established networks of collateral providers and receivers, could prove to be a key facilitator to building greater adoption.
Optimisation
No conversation around collateral supply and demand is complete without covering optimisation. Ensuring the most effective use of collateral has been core to collateral management for the past 20 years. Approaches vary. Large firms — many of which have already developed in house algorithms to optimise collateral at a granular level, calculating the most optimal allocations of collateral depending on the prevailing regulatory constraint of the day — are increasingly expanding those algorithms to capture greater scope of the firms’ cross-enterprise inventory and exposures.
Smaller firms can benefit from a vendor approach with many off-the-shelf optimisers available, often already integrated with industry infrastructure and standards. There is seemingly no endpoint for building out an optimisation solution. As rules, regulations and trade structures evolve, so will the inputs and desired outputs of the optimiser algo.
Data strategy is the backbone of such an ecosystem, as is the ability to not only calculate the most optimal outcome but also to deploy that effectively through collateral mobilisation and enable as nimble and as future-proofed a solution as possible.
Effective data strategy also makes the adoption of advanced analytics tools and artificial intelligence more of a reality, unlocking a multitude of opportunities that enable more refined negotiations of trade terms, better preparation for market events, as well as faster and controlled data workflows.
Change is the only constant
The interdependency and complementary nature of many of these initiatives demonstrates the collateral ecosystem in its truest sense — many roles, actors, and relationships being expanded and supplemented by new elements and buffeted by the mega-trends seen more broadly in financial services of globalisation and digitalisation.
Collaboration and stamina are both necessary, as use cases cannot be proved out in isolation and can take many iterations. Through partnership, we have the best opportunity to identify the most optimal solution, road test its effectiveness, and build momentum for broader industry adoption.
The expected Basel III Endgame rules coming into effect from 2025-26 and the long tail of segregated initial margin implementation are two drivers of increased demand, while the growth of new collateral markets and digital innovation represent examples of how supply and mobility of collateral is expanding in parallel.
Capital efficient structures
Given the potential impact of Basel III Endgame, it comes as no surprise that capital efficiency continues to be near the top of the in-tray for many sell side firms. There is no one-size-fits-all, and approaches should be seen as a suite of options, deployable to target different challenges, depending upon the relative and dynamic inputs and constraints of the individual firms.
Key areas of focus that have been leading our discussions include pledge, transfer title pledge-back, and securities financing-focused central counterparties (CCPs).
Exchanging collateral under a pledge arrangement for securities finance has been established for a number of years, with the market coalescing around standardised documentation and a standardised operational model. Pledge has worked well, mainly for non-US banks with increasing uptake expected as we move towards 2025 and beyond.
Driven by the differing client needs such as those of US-regulated banks, an augmented approach is ‘transfer title pledge-back’, where collateral is transferred under full title, with either the margin or full collateralised amount, pledged back to the collateral provider — the aim being to help reduce the cost of capital associated with the unsecured exposure caused by over-collateralisation of the margin.
Reduced capital footprint is a key benefit of transacting through a CCP, and we are seeing strong collaboration across the collateral ecosystem in both securities lending and repo on both sides of the pond. Combining new securities finance cleared models with the established automation and scale of existing industry solutions like triparty, offers the opportunity of market adoption at scale within tangible timeframes.
Intraday liquidity
Traditionally, liquidity can take many forms, at its simplest as credit lines, excess cash, or security buffers (eg longboxes in triparty parlance). But more recently, we have been able to help facilitate more complex approaches to structuring and sourcing liquidity.
Liquidity is not cost-free, attracting commitment fees, direct usage fees, or the indirect cost of forgoing the benefit of a fully funded inventory. As settlement cycles shorten, technological advancements increasingly enable real-time, firm-wide monitoring, as does the monetisation of liquidity intraday, with the cost to use liquidity in some cases starting to be applied by the minute.
Repo has long been a key pillar of liquidity management with sell side firms raising cash to the tenor and currency as necessary, providing a yield to the buy side in return. As liquidity requirements gravitate to intraday, so too has the need for intraday repo, which as a structured trade can be more cost efficient than incurring liquidity costs at a custodian, triparty agent, or infrastructure provider.
Intraday repo through blockchain has been one area of focus and has been a reality for a number of years. The same goes for the ability to transact intraday repo through traditional triparty — providing an additional source of liquidity for dealers and yield enhancement for cash providers.
From a triparty programme perspective, we have seen a number of alternative approaches to source additional securities collateral that can be used to provide liquidity for allocation, substitution, and optimisation strategies throughout the day. Some strategies include sweeping excess collateral to be made available intraday, others include more structured trades such as high-quality liquid asset (HQLA) contingent funding trades.
Collateral expansion — emerging markets
Expanding collateral supply can take a number of forms, with expansion of existing product scope to new geographical locations perhaps the most obvious but not always the most straightforward. Local regulation, legal requirements, and tax or market settlement processes can necessitate bespoke or innovative solutions.
As emerging markets build out the full breadth of financial services infrastructure, use of issued securities as collateral is often not at the forefront of regulator or legal frameworks, however important a post-trade activity it has become.
As a collateral practitioner, adding incremental markets can take time to undertake due diligence and understand local market nuances to augment standard international product offerings to the local market requirements. Led by success in the Asia Pacific region in recent years, the collateral ecosystem has developed a good cadence for adapting to new markets like South Korea and Taiwan, and we see a promising pipeline of new collateral markets including Saudi Arabia, South Africa, Indonesia, and Malaysia.
Simply adding a new market does not necessarily mean adoption is immediate and substantial. Building that network of providers and receivers comfortable with documentation and operational processes can take time.
Mexico is a market we have long served, and after steady initial growth, we are anticipating strong uplift over the next year there. While initial margin collateral requirements under the Uncleared Margin Rules (UMR) have been live across major jurisdictions since 2016, mandatory posting of regulatory initial margin is effective in Mexico from 31 December 2024 and is proving a catalyst for triparty adoption, initially to satisfy for UMR, but also a stepping stone for other types of collateral management and securities financing activity.
Many local firms are excited to set up triparty, not only for their initial margin requirements, but as it will be a bridge to expand financing opportunities such as repo with Mexican-issued securities and pesos.
Collateral expansion — digital assets
In addition to increased operational efficiency and collateral velocity, part of the appeal of digital assets is to improve liquidity by increasing fractional ownership through asset division or transfer of baskets through aggregation, making assets more accessible to a wider range of investors.
Tokenisation also offers the opportunity to expand the supply of collateral, ranging from tokenisation of physical assets, individual assets, or a pool of securities. Once assets are tokenised, ownership can be transferred across the blockchain at speed, scale, and transparency throughout the chain.
Real world examples of how this can expand the scope of collateral markets include money market funds (MMFs) — long regarded as a great source of credit but with limited transferability between counterparties limiting their utility as a form of collateral. Tokenised MMFs retain the same credit qualities but are freely transferable and are now being used as initial margin, expanding the potential supply of available collateral for the broader ecosystem.
Similar to the issuance of natively digital assets, which we have seen through a number of nascent private blockchain platforms, a key factor for greater adoption hinges on whether digital assets can be mobilised once acquired and whether they can be used as collateral or be financed. Therefore connecting private blockchains issuing digital assets, with the full suite of triparty functionality and established networks of collateral providers and receivers, could prove to be a key facilitator to building greater adoption.
Optimisation
No conversation around collateral supply and demand is complete without covering optimisation. Ensuring the most effective use of collateral has been core to collateral management for the past 20 years. Approaches vary. Large firms — many of which have already developed in house algorithms to optimise collateral at a granular level, calculating the most optimal allocations of collateral depending on the prevailing regulatory constraint of the day — are increasingly expanding those algorithms to capture greater scope of the firms’ cross-enterprise inventory and exposures.
Smaller firms can benefit from a vendor approach with many off-the-shelf optimisers available, often already integrated with industry infrastructure and standards. There is seemingly no endpoint for building out an optimisation solution. As rules, regulations and trade structures evolve, so will the inputs and desired outputs of the optimiser algo.
Data strategy is the backbone of such an ecosystem, as is the ability to not only calculate the most optimal outcome but also to deploy that effectively through collateral mobilisation and enable as nimble and as future-proofed a solution as possible.
Effective data strategy also makes the adoption of advanced analytics tools and artificial intelligence more of a reality, unlocking a multitude of opportunities that enable more refined negotiations of trade terms, better preparation for market events, as well as faster and controlled data workflows.
Change is the only constant
The interdependency and complementary nature of many of these initiatives demonstrates the collateral ecosystem in its truest sense — many roles, actors, and relationships being expanded and supplemented by new elements and buffeted by the mega-trends seen more broadly in financial services of globalisation and digitalisation.
Collaboration and stamina are both necessary, as use cases cannot be proved out in isolation and can take many iterations. Through partnership, we have the best opportunity to identify the most optimal solution, road test its effectiveness, and build momentum for broader industry adoption.
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