Dealers turn to Asian assets for liquidity swap trades

Dealers access JGB pools for collateral upgrade trades – with Australian and Singapore dollar deals on the horizon

Last summer, BNY Mellon began facilitating a rather unusual trade flow out of Japan. The firm was using its Japanese trust bank as a vehicle to allow offshore broker-dealers to borrow Japanese government bonds from onshore lenders for terms of up to two years in exchange for a fee and lower-grade collateral. The JGBs would then be whisked away to be used as high-quality collateral in deals elsewhere. The platform has grown from one initial broker-dealer and lender to multiple broker-dealers and more than a dozen lenders. There have been numerous liquidity swap – or collateral upgrade – JGB trades, with asset values totalling several billion dollars.

This trade flow is unusual for several reasons. First, according to the latest over-the-counter derivatives margin survey from the International Swaps and Derivatives Association released in June, cash continues to be the dominant collateral pledge in OTC derivatives trades around the globe. Cash has maintained a level of around 80% of delivered collateral for several years and in fact marginally increased its year-on-year ratio. In Asia, market players reckon the ratio to be even higher than 80%. Around the world, those government securities that are used as collateral are predominantly from the US and the EU.

Second, the liquidity swap trade has lost some of its lustre since capital pressures on banks eased as the worst of the financial crisis subsided after 2011, while the Basel Committee on Banking Supervision relaxed its criteria on accepted assets for the liquidity coverage ratio (LCR) early this year.

In any case, the liquidity swap trades that were conducted in Asia mostly focused on US Treasuries, market participants report, and buy-side players say that while they still receive offers from the banks for Treasuries, the rates on offer are no longer quite as attractive as they were three years ago. This mirrors the trend in the UK market where players are reporting the 150bps pick-up previously received is no longer available.

But it's worth noting that Isda reports the use of JGBs as delivered OTC collateral actually increased year-on-year up to the end of 2012. This is true both in real terms ($23 billion to $30 billion) and in percentage of overall collateral terms (2% to 2.4%), while US, EU and UK sovereign bond use fell in both instances. It's hard to tell how much of that increase remained onshore but it's a significant bump up since firms began demanding more collateral post-crisis – levels have hovered between $17 billion and $23 billion since 2009. More JGBs were used as collateral in dollar terms than the yen itself, which amounted only to $26 billion delivered in 2013.

Indeed, the demand is clearly there, with BNY Mellon's offshore JGB lending business tripling in the first nine months of 2013, according to Dominick Falco, Hong Kong-based Asia-Pacific regional head of global collateral services at BNY Mellon.

"You always hear about these shortfalls of collateral around the world. Well, JGBs are widely accepted collateral, so we're providing a vehicle for people to access onshore Japan for their collateral needs outside," he says.

Falco explains that in exchange for equities or lower-quality fixed-income securities, broker-dealers would borrow JGBs for anywhere between six months and two years.

"Then those JGBs will typically be used in other types of collateral deals where broker-dealers need to raise higher-quality collateral. They can put it up to central counterparties and in some cases even repo the transaction," he adds.

It's not just JGBs. Falco says there has been discussion to do the same with Australian government bonds and Singapore government bonds, although no deals have yet been confirmed.

"The infrastructure is there for Australian government bonds to work and it's just a question of finding the right holders to put them through the platform," he says. "We're also talking to a variety of Singapore entities to come onto the platform in a couple of different ways, either as collateral provider or receiver. In one case, we are talking about a collateral upgrade trade with them where they would take in a variety of corporates and get Singapore government bonds which they would use for their own purposes."

The liquidity swaps market first sprang up in London in the wake of the financial crisis as banks desperate for liquid assets were structuring term loans with buy-side firms, swapping their lower-quality assets for highly rated liquid bonds for tenors up to 10 years.

There has been much regulatory ambivalence around the structure. The UK regulator at the time, the Financial Services Authority, was concerned over the types of collateral insurers were accepting in exchange for their government bonds and that insurers would not be capable of managing the risks. It was also concerned that such transactions could increase systemic risk by creating further links between banks and insurers. As a result, the FSA blocked several deals in 2011, before publishing guidance in February 2012 which formally allowed liquidity swaps under certain conditions.

Despite this explicit approval, Andrew Bailey, currently chief executive of the Prudential Regulation Authority, reiterated regulatory unease over the deals in February this year.

However, one Hong Kong-based senior banking source familiar with these types of deals says that there is an important distinction between the trades that were carried out which worried the FSA and other types of collateral transformation.

"The terminology ‘collateral transformation trade' actually fits quite a large number of different trades. In the UK there were some trades done with very illiquid collateral, sometimes between banks and bank-owned life insurance companies that made the regulator uncomfortable. But under the same terminology you could have trades that value quite liquid collateral with much shorter tenor and one would have to distinguish between the types," says the senior banking source.

If risk-managed properly, there are good arguments around doing the trade, he says.

"From a theoretical point of view, there is a good rationale as to why insurance companies should do this trade. There has been solid debate around this. There is an illiquidity premium that insurance companies should effectively seek to obtain. If you hold large amounts of government bonds on your portfolio, it is arguably too liquid compared with your liabilities and this would be one way to enhance it," says the senior banker.

This relaxed stance is shared by regulators around the region: the Japanese Financial Services Agency (JFSA) told Asia Risk that it was not implementing any special measures in response to the increase of liquidity swaps by domestic players. This was repeated by the Australian Prudential Regulation Authority, Hong Kong's Office of the Commissioner of Insurance, and the Monetary Authority of Singapore when contacted by Asia Risk.

Market sources believe between five and eight international banks are active in this trade – however none of the firms approached by Asia Risk wished to comment for this article.

Regulatory pressure elsewhere is an obvious driver for the trend, even if it has eased somewhat. Even though a Bank for International Settlements Quarterly Review study in September concluded that there will not be a shortage in high-quality assets for collateral purposes, the same study accepts that due to OTC derivative regulatory reform and LCR requirements, collateral demand will continue to grow, while there is "uneven distribution of collateral assets" leading to "possible...localised and temporary supply-demand imbalances".

David Little, London-based director of strategy and business development at Calypso, points out that Asia's cash reliance is going to catch up with market players once the LCR and other regulations start to kick in.

"In the world as a whole, in general many collateral agreements have the ability to exchange non-cash collateral but apart from the largest dealers, very few people take that up. The vast majority use cash and in Asia that's particularly true," he says.

Little says that outside of major dealers in their flows with each other, where they may use non-cash, there isn't the practice of using non-cash.

"As soon as you get to local banks and buy-side firms, it's pretty much cash only. They need to change from that because they're going to have to deliver more collateral and unless they happen to have a lot of cash on hand, they're going to have to liquidate funds and assets in order to be able to deliver it," he says.

Cost will be a major driver of change: with global rates at all-time lows, cash collateral makes perfect sense. But at some point rates will have to head north, changing the market dynamic and increasing demand for securities as collateral, says Stefan Lepp, head of global securities financing at Clearstream, the custody and settlement subsidiary of Deutsche Börse.

"Given the still generous money policy of major central banks, today cash is easy to mobilise because it is cheap and it is relatively easy to transfer but this might change in the future because at a certain point, the central banks will change course, interest rates will go up and cash will become more expensive and then everybody will want to use securities as collateral," he says.

And according to one Hong Kong-based head of investments at a major insurer, this scenario would see an increase in Asian collateral use even if the issue of haircuts for non-US Treasuries is not resolved – currently even triple-A rated securities require haircuts from anywhere between 5% to 20% depending on name, structure and maturity.

"More Asian sovereigns could be used in collateral. One issue is that a lot of these collateral agreements are done on a case-by-case basis. If your counterparty is willing to take Asian sovereigns and you are willing to post Asian sovereigns and obviously receive them in return, that's doable. Because right now all the agreements we've seen use cash but if you want to post even US Treasuries, there's a slight haircut and then there's a bigger haircut for other securities," says the insurer.

"But as rates go up and cash becomes more and more expensive, it is more efficient to post Asian securities, even if there may be a haircut," adds the insurer.

BNY Mellon's Falco says that time zones could also make using non-Asian collateral awkward.

"One of the problems you have with global collateral is that if you're pledging US Treasuries in this part of the world, it either has to be in position the day before or you're going to take an overnight exposure on one side, which is never ideal," he says.

In terms of regional infrastructure, obstacles are steadily being cleared that will allow transfer of Asian collateral between borders and between central counterparties. BNY Mellon has in place the infrastructure to facilitate similar collateral transformation term lending trades out of Australia. Market players told Asia Risk that there have been discussions with international clearing houses over expanding the list of accepted collateral to include instruments like Singapore government bonds.

"Part of the narrative in Asia is encouraging central banks, regulators and exchanges to be more expansive in the types of accepted collateral. Surely the central banks will be looking to diversify their holdings more away from dollar assets. There are a lot of good assets in Asia that could be recycled," says Andrew Pal, Singapore-based executive director of prime services at UBS.

One hindrance at the moment is the relative illiquidity of the assets compared with US Treasuries. There may be a large number of high-quality assets available in Asia but according to Michael Syn, head of derivatives at the Singapore Exchange (SGX), these may not meet the standards set out in the CPSS-Iosco principles for financial market infrastructure. The principles specify that financial market infrastructure providers accept collateral with low credit, liquidity and market risks.

"The standards from CPSS-Iosco require a clearing house to take great care over choice of collateral. SGX philosophy is to offer a flight to quality halo for market participants during times of financial stress. Therefore our choice of collateral is dictated by its risk and liquidity characteristics," he says.

For non-cash assets, SGX currently accepts US Treasuries, German Bunds, French OATs, JGBs, Singapore government bonds and liquid SGX-listed shares. Syn says the exchange does not accept Australian bonds because it doesn't currently clear in Australian dollar-denominated instruments. However, the Australian dollar constitutes one of the main currencies that make up global central bank forex reserve holdings as measured by the IMF. This gives it hard currency, safe haven status and importantly, Syn does not rule out its future inclusion.

"Collateral management is a key focus for SGX, and the idea would be to make Asian securities in various Asian jurisdictions acceptable in the collateral pool. Secured lending against these securities would liberate more capital for the purposes of central clearing at SGX, and we are working closely with global market participants, issuers and investors to put the requisite multi-currency multi-asset market infrastructure in place," says Syn.

"SGX is undertaking initiatives to build market infrastructure to mobilise Asian securities for circulation in the global collateral pool. SGX itself is a depository of some S$1 trillion in assets," he adds.

To this end, in September, SGX became the latest addition to Clearstream's global liquidity hub, joining ASX as the second infrastructure provider to sign up in Asia. Clearstream outsources its collateral management technology to financial infrastructure providers and after first going live with Brazil's central security depository CETIP in 2011, it has since made agreements with similar institutions in Canada, South Africa and Spain.

The market players themselves in the region will also need to make structural changes to be able to start exchanging more non-cash collateral, according to Calypso's Little. He points to the example set by the larger international banks, where special front-office collateral management desks are being created.

"In banks, you're seeing a new desk being created that is an enterprise-wide collateral front-office desk, something that never existed before. Then they need to create a target operating model, which gives them a plan of action. The target operating model attempts to get a view across the enterprise of all of their collateral assets and run some analytics on that. Then they have to make sure their operational systems are up to scratch and can cover everything," Little says.

"The long-run aim is to be able to support non-cash and be able to do some form of collateral optimisation. They often tie it to liquidity. Those collateral assets, as well as being required for margin purposes, are also what you use to raise short-term liquidity in the repo markets, if need be. So liquidity and collateral are becoming much more tied together," he adds.

Equity collateral Asian equities are also catching on for collateral use, according to Swen Werner, Hong Kong-based product head for collateral management, Asia-Pacific at JP Morgan. Even though several jurisdictions in Asia have ruled out equity as permissible assets for the liquidity coverage ratio, he says there's a lot of interest in using highly liquid Asian equities as collateral. Indeed, alongside the more well-established markets in Hong Kong and Singapore, this summer JP Morgan began accepting South Korean equities as eligible collateral on its global triparty platform, with counterparties having already submitted such assets, although volumes were unavailable. "There is demand in the market to make more use of Asia-Pacific assets – particularly equities – to secure all kinds of transactions. The interest for clients outside of Japan is more on the equities than in fixed income in Asia, simply because the outstanding amount of government securities in Asia is relatively small, so people are asking what they can do with Hong Kong or Singapore equities," says Werner. "We just have to make sure people are aware these options exist – there's nothing preventing them from doing these trades and people are very open to these ideas. There is now a bigger appetite to use Asian assets as collateral than maybe two years ago," adds Werner.

 

New LCR and likely Asian interpretations In January, the Basel Committee on Banking Supervision published a revised text on the liquidity coverage ratio, a requirement that banks have sufficient liquid assets to cover net cash outflows over a 30-day period under stress. In the new LCR, alongside level 1 assets requiring no haircuts, such as cash and top-rated sovereign bonds and level 2A assets, made up of highly rated corporate debt that came with a 15% haircut, was an additional level of eligible assets, called level 2B. These had haircuts between 25% and 50%. Level 2B assets included residential mortgage-backed securities (RMBS) with a long-term credit rating of AA or higher, corporate debt securities with a long-term credit rating between A+ and BBB–, and certain listed non-financial equities. The key outlier, however, was that unlike the highest-quality assets such as AAA sovereign bonds, inclusion in nationally implemented LCRs was at the discretion of the regulators. Some of the regulatory actions are as follows: • In May 2013, the Australian Prudential Regulation Authority stated it would not consider including level 2B assets in its latest LCR proposal.   • The Hong Kong Monetary Authority proposed only to recognise single-A rated corporate debt securities and RMBS rated AA or above in its July consultation.   • In August, the Monetary Authority of Singapore excluded RMBS and equities from its eligible LCR assets and only permitted corporate debt rated single-A and above.   • Early in October, the China Banking Regulatory Commission permitted BBB– corporate debt in its new LCR proposal, but continued to exclude RMBS and equities.