The Protagonists:

Olivier Grimonpont is director and head of Euroclear's Collateral Services, Fixed-Income, Loan Servicing and Securities Lending & Borrowing Product Management teams. Based in Brussels, Mr Grimonpont's team is responsible for the support, development and management of these core services to Euroclear clients.

Pascal Morosini is executive director, head of GSF Sales and Relationship and in charge of selling Global Securities Financing services to all Clearstream's clients. He joined the Cedel Group in 1994, starting in Operations to deal with collateral valuation.

Mark Higgins is vice president and head of Business Development for EMEA Collateral Management at The Bank of New York Mellon. Mark has extensive collateral management experience having previously held a product management position at Lombard Risk Systems.

John Rivett is the Global Product manager for J.P. Morgan's Securities Collateral Management business, covering both stock loan and repo collateral management. In this role he has oversight for strategic initiatives.

David Little is head of Securities Finance at Rule Financial. He began his career in oil exploration but gave up dynamite for software and the City. At UBS Warburg he became an expert in securities finance, working on the assessment, installation and integration of trading systems for SBL and repo.

The Debate:

1. How has the credit crunch affected collateral management?

Morosini: Our volumes have never been so high with record peaks at EUR433 billion in November 2008. Our wide customer base composed of private banks, commercial banks, central banks,  internationational banks, investment banks, and local and global custodians has enabled us to support various collateral structures in the last 12 months. Allocations to central banks for tenders and central counterparty (CCP) has grown exponentially. The quest for secured products and liquidity has benefited Clearstream because of its access to central banks and cash via the Euro GC pooling repo offering with Eurex. Funds, insurance companies, and asset managers  are now willing to be more secured towards their custodian or bank, pushing the collateralisation for securities lending to an all time high. Some counterparties have awoken to the unsecured risk they were running in their business - and this has been driving a large part of the volumes. Collateral to cover: Cash Correspondent Credit lines, Securities Loans, Cash deposits, Derivatives, Structured Financing etc. are common these days.

Grimonpont: The recent liquidity and credit crisis means that there is a temptation for firms to curtail their lending activities.  However, those firms that are monitoring their risks, exposures and collateral positions tightly are taking advantage of business opportunities while maintaining an attractive risk/return ratio. Therefore, it should come as no surprise that when firms now trade with each other, they are taking measures to collateralise their exposures against stricter eligibility criteria, with shorter maturities, wider spreads and higher margins. They are also seeking to make the collateralisation process as risk controlled and efficient as possible. We expect this trend will continue into the foreseeable future as an appropriate business practice and, in time, possibly as a result of more stringent regulatory pressures.

Higgins: We have seen a significant growth in the use and acceptability of collateral in the past year.  We support the use of collateral as a traded asset in tri-party and as a risk mitigation tool in the OTC derivatives markets.
    Throughout the liquidity crisis cash has become harder to access and terms for collateral eligibility increasingly stringent. Collateral schedules were updated during the crisis, reflecting a flight to quality. Many required only minor adjustments, which perhaps reflects the greater awareness of risk.
    On the risk mitigation side, we have seen considerable volumes of cash collateral, which only goes to reflect the recent statistics published by ISDA. It's still very much cash and government bonds.

Rivett: Counterparty risk now has a very high profile in all organisations and collateral management is an important mitigant of that risk. Lenders have narrowed their range of acceptable collateral, focusing on fixed income because of the volatile equity markets, and increased their haircuts. Counterparties have also moved towards entities that have acknowledged strong financial balance sheets in a 'flight to quality'.

Little: In so many ways the big names have disappeared. Those remaining are rethinking their business strategy from the top down, causing extreme volatility. But I think I'd single out liquidity issues as the most significant for collateral management. The lack of liquidity in the money markets and unsecured businesses has driven banks towards repo and tri-party repo in particular. The lack of liquidity in some securities and asset classes has also caused huge difficulties and made pricing and valuing positions, even of good quality securities, almost impossible at times. However, the regulators are now focusing on liquidity risk and we will see a major effort to measure and tame this over the coming year - but the benefits of collateralised over uncollateralised lending are undisputed.

2. What will be the impact of the recent FSA liquidity risk guidelines on the market?

Morosini:  We saw the impact of these guidelines before the FSA issued them. Liquidity management has been the hot topic in 2008 and many institutions have worked towards establishing all possible routes to liquidity starting with mobilising all assets belonging to different entities of the same group through triparty collateral management. Many liquidity managers have pushed repo desks to put contracts in place with counterparties "just in case" despite no immediate economic benefits. Liquidity has become the priority before profits. This is why all Clearstream Collateral Management participants are setting up the route to the FED discount window to access the TAF, to the ECB, to Euro GC Pooling of Eurex and to other long cash institutions in order to demonstrate their capacity to access liquidity. We even saw members of the same group establishing the same routes, having their own access on top of being interconnected themselves to strengthen their potential via rehypothecation in triparty.

Higgins: From a collateral perspective, liquidity is key. Historically, collateralised lending has been the sustainable method of ensuring liquidity in periods of turmoil. Within The Bank of New York Mellon's Global Collateral Management programme, there is a greater demand for the re-use of collateral. Collateral can no longer only be used for the initial move, it needs to be re-used to gain the required efficiencies. Now that most firms have moved to a fully collateralised environment, we are seeing a greater demand for collateral. To avoid a collateral shortage in the market, firms can no longer afford not to re-use collateral. And if a cash lending firm needs to raise liquidity, they must be in a position to benefit economically from collateral received.

Rivett: The FSA's desire to introduce a liquidity risk measure by taking the difference, over a given period, between 'stressed' inflows and outflows and dividing them by non-capital liabilities is an understandable addition to their regulatory framework. Companies will be better positioned to understand their future cash positions. They should develop a strategic approach to term repos and financing transactions to manage this risk. While term repos do have other risks associated with them, if they are managed correctly they will provide a useful tool.

Little: The impact will be greater than most people realise. The requirements are far reaching and go beyond the basic additional reporting obligations. There is also a requirement for more modelling and stress testing in order that UK legal entities protect themselves against the actions of other legal entities in the same group. This all adds up to big changes in 2009. Companies with modern flexible risk architectures will be significantly better off, but it won't be easy for anyone.

3.Collateral reinvestment risk is one of the main areas of concern in the industry at the moment, what is your view?

Morosini: We don't use cash as collateral. Although it has affected us on the revenue side, we have kept many lenders in our programme because the collateral is composed of A- Bonds being ring fenced and kept on their behalf. Our simple 'bonds versus bond' model proves to be safe and secure.

Grimonpont: Taking securities as collateral is the simplest and most secure market practice to follow, guaranteeing their return at the time of trading. A triparty agent such as Euroclear Bank is able to enhance returns by accepting more complex collateral, as the agent provides a well-controlled risk environment. This is the model that still prevails in Europe. However, we acknowledge that there might be cases where cash is considered the best form of collateral for mitigating risk or as a means to add extra revenues. In both cases, cash collateral reinvestment is a business in and of itself, with its own risks and returns. Firms willing to use cash as collateral should understand the risks and rewards of both the securities lending and cash reinvestment.

Higgins: When understood and controlled, it is something to be used and viewed positively. For example, the ripples from Lehman's have created an increasing demand from both buy and sell side organisations looking to provide segregated collateral accounts with The Bank of New York Mellon. Rather than post all collateral to a dealer as the funds would have usually done (net mark to market and independent amount), we have received requests to provide creative assistance and ways to 'ring fence' assets. We have been able to apply traditional tri-party mechanics to support derivatives based exposures and activities. The central custody of the collateral by the custodial agent, as with tri-party, presents an ideal way to access the stock loan and repo markets while knowing that much of the collateral posted will remain in full view at The Bank of New York Mellon.

Rivett: Volatile markets, by their very nature, will increase this risk. Mitigation of this risk has to be conducted as part of a larger strategy of hedging an entity's exposure to this volatility. This can be expensive and hence the returns from such transactions are reduced.

Little: Hedge funds have been particularly badly hit. According to the Financial Times, USD 22 billion of the USD 40 billion held by Lehman's European Prime Brokerage had been rehypothecated. Hedge funds haven't been able to get these assets back and may have to wait years to get a proportion of their money returned. This is likely to be a defining moment for the industry and it's still too early to say whether it spells the end of rehypothecation; it certainly means it will be priced and monitored more closely. One option would be for a more limited use of rehypothecation where prime brokers could just use the hedge fund long positions for their capital requirement under Basel II. This would reduce the risk of having to get the stock back as it would only be held in the prime broker's depot.

4.Historically collateral management has been very silo based. Can you see a drive away from this?

Morosini:  Some groups have had strict instructions to mobilise all collateral from all pools within the group to allocate them to the ECB or the FED. Most institutions had collateral management teams that have suddenly became a more important function. In some institutions, the collateral still remains fragmented in silos with different usage of triparty collateral management. This is mainly due to the fact that there is no centralised collateral management function serving the needs of the treasurers, repo desks, borrowing and lending desks, derivative desks etc.

Grimonpont: In many firms collateral is still managed per business line. I believe those days are over. The recent credit crisis has accelerated this change. It makes no sense for firms to have one line of business wasting good collateral while another is struggling to finance with poor collateral. Similarly, it makes no sense to exchange large pieces of collateral back and forth between business lines, when centralised collateral management increases efficiency by only requiring collateral to cover netted exposures. This is no different from the cash side of the business where, a few years ago, it was not unusual to see different businesses within the same firm lending and borrowing cash with the same external counterparty instead of centralising the financing needs of the entire firm. This practice is now in place at most firms and will become common practice for managing collateral as well. Granted, centralised collateral management is more complex, but the potential benefits are even larger.

Higgins:  Over the last ten to fifteen years many of the larger banks have moved their operational and risk management functions to within central 'Global Margin/Collateral Management' units. This has given them economies of scale and extended levels of operational risk control. It is now very common to have the SBL, repo, prime brokerage, derivatives and event ETD margin management lines of business all working together, often with the same technical platform.  The next challenge will be to see if the business lines can or will need to move closer together. For example, should the fixed income and equity repo/SBL business be separate or would they benefit from operating under one functional line.

Rivett: The increased requirement for collateralised transactions in combination with the need for entities to squeeze more value from their portfolios will drive collateral management away from silos. A risk manager who can draw on a single pool of assets to collateralise any type of transaction will be more efficient.

Little: The trend towards a global cross asset view of collateral has been evident for some years. Current events will strengthen this trend. Vendors are improving their products to offer genuine cross asset capability. I don't think anyone questions the benefits of merging the silos, but the expense is considerable and it isn't necessarily the highest priority for institutions.

5.What are the major advantages of using a triparty?

Morosini: Well, the "old" core features such as multiple assets, multiple currencies, eligibility checks and sufficiency checks and the right of unlimited substitutions are the main key differentiators from bilateral agreements. Combined with the rehypothecation feature, in place since 2006, and the increasingly sophisticated eligibility criteria, it is a powerful and reliable way of many types of securing exposures.

Grimonpont: There are a number of critical issues in collateralising transactions.  One is making sure that the required collateral is in the right place at the right time. Another is making sure firms are optimising the use of the collateral, that is becoming increasingly scarce due to the demands placed on it. Third,  it is vital for firms to understand the procedures and challenges inherent in liquidating collateral in the event of a counterparty default during the life of the transaction. When the worst happens, it is critical to have immediate and reliable information on the collateral received as well as immediate access to collateral. Euroclear Bank, as a triparty agent, enables the immediate transfer of collateral minutes after an event of default is declared.
    We think transactions between counterparties will be increasingly collateralised and there will be greater focus on managing the various risk-related parameters involved in managing collateral, such as haircuts and concentration limits, which makes the issues identified above even more difficult to manage.
    The use of a triparty collateral management agent like Euroclear Bank is an excellent way to manage these issues.  We are particularly well placed to manage collateral for clients very efficiently. The service provided is settlement integrated, and highly automated and flexible while providing timely and granular collateral use reporting. Triparty agents, like Euroclear Bank, will be increasingly viewed as the most reliable and safe venues in which to collateralise business.

Higgins: Cost, control, access to new business, better risk management to name but a few. The automation of the collateral selection process greatly benefits the collateral giver of securities as it allows them to concentrate on trading in the knowledge that collateral is always perfectly allocated while within easy reach via substitution. Some organisations enter triparty as a way to reduce the operational risk associated with placing and managing the life cycle of a trade in the bilateral world. For example, you may want to invest cash in the repo market but don't have the ability to book, value and position keep a portfolio of deals. With triparty, you have appointed the central agent to calculate the value of the cash accrual, collateral portfolio and resulting margin requirement. This is all packaged up neatly in a nicely reportable format.
    I think triparty will start to be seen in a new light and not just in the traditional sense of supporting collateral trading. Its many advantages are working their way into the derivatives sector as we speak.
    
Rivett: Triparty agents are experienced collateral operators who have invested heavily in infrastructure and technology to mitigate collateral management risks and provide counterparts with a transparent and efficient service.  It reduces the cost of entry and minimises settlement risk and transaction costs while also enabling clients to execute same day recalls and substitutions. Triparty lends itself to the 'single pool of collateral' concept - most agents have an optimisation engine of some kind that allows a collateral provider to allocate collateral efficiently, irrespective of the underlying transaction.

Little: There are many advantages in a triparty arrangement: operational efficiency in the front and back offices, intra-day margining, use of small collateral lines, automatic substitution and reduced credit risk being the main ones. These advantages have led to the continued rise of triparty over bilateral lending. Triparty lending also coped remarkably well with the fall of Lehman Brothers, when the agents were able to settle counterparty claims on collateral within a few days. But there are also drawbacks. The lack of visibility and inconsistencies in static and market data are two notable ones. Until recently, triparty agents provided limited reporting of collateral allocations to the principals. Under Basel II and in current market conditions, counterparts are demanding - and getting - daily or intra-day feeds of allocations so they can monitor the exact collateral exposures. Pricing discrepancies between the parties can lead to significant differences of opinion on collateral values. There can also be a lack of standardisation in message formats and content between tri-party agents.

6. Over the past 12 months have there been any major changes in the rules and agreements that constitute bilateral transactions?

Morosini: Certainly, any adhoc or home-based contracts have been replaced with industry contracts such as the GMSLA or the GMRA. This provided a more industry-like market practice especially for liquidation and valuation of the collateral. After the Lehman default more stringent collateral profiles were established and the default procedures have been reviewed.

Grimonpont: We have seen changes in collateral-eligibility profiles - the trend started off modestly then became substantial with the Bear Stearns scare, and has become drastic since Lehman's collapse. Maturities shrank; haircuts and spreads exploded.
    Clearly, the intense focus on managing exposures against a wide range of risks is a driving force for collateralisation, both bilaterally and through triparty. It is no surprise to see so many initiatives providing central counterparty (CCP) services for securities lending transactions as well as for general collateral financing products. The delivery of a seamless rehypothecation feature in collateral management, such as that offered by Euroclear Bank, was a prerequisite to the introduction of a CCP in this domain.
    I would also not be surprised to see more regulations placed on banks and other financial institutions to meet higher capitalisation requirements and to run their businesses against more stringent risk management criteria. Market participants will also look for efficient triparty collateral management services through which to allocate pools of eligible collateral in order to obtain seamless access to central bank credit facilities.

Higgins: Since the beginning of this century we have seen a stabilisation of generally accepted market terms and agreements. The Credit Support Annex (CSA), Global Master Repurchase Agreement (GMRA) and Global Master Securities Lending Agreement (GMSLA) are now widely seen as setting the bilateral standards for derivatives, repo and stock lending transactions. But as with past events, we can expect to see new ideas and policies working their way into these types of documents in future. For example after market defaults in the late 1990s, The International Swaps and Derivatives Association (ISDA) worked with the market to publish the 2001 Margin Provisions document. A paper technically admired by many but applied by few as it was too hard or expensive to apply many of its directives.
    In the triparty space we do not see what is negotiated on a bilateral basis, although we see directly what both parties consider as acceptable collateral and the terms under which it can be applied. And as mentioned before, we have seen all sorts of movements up and down in this area over the last year.

Rivett: As mentioned earlier, most agreements probably have narrower eligibility rules, even in the bilateral world. The default of a major investment bank, in many ways, actually proved the strength of the legal agreements GMRA and GMSLA, as the majority of counterparts were able to take possession of their collateral and realize its value for their own purposes.

7. What change in the demand for collateral has occurred in the last 12 months?

Morosini: More haircuts, more quality bonds, more liquid securities, more concentration criteria - anything that could contain and soothe the collateral liquidity crisis. Also, we have seen many new types of institutions requesting collateral, sometimes in a rush because they discovered they were exposed for many years -sometimes 100% unsecured.

Grimonpont: Exposure collateralisation was certainly a common practice a year ago. We are now seeing a broader mix of firms that are collateralising exposures across a wider spectrum of transactions, i.e. repos, securities lending, secured loan and derivatives transactions, as well as for central counterparty margin management purposes. As a result of the recent, increased inter-mediation by central banks in order to ease the pressures within the inter-bank money markets, we have seen increased focus on the collateralisation of central bank credit facilities. We have also seen a gentle tightening of the collateral eligibility profiles in 2007 and a more sharply defined trend in 2008. Collateral takers are now more thoroughly reviewing the basket of collateral they are willing to accept. 
    It is very important for triparty agents to be clear and transparent about their collateral valuation methodologies (including price sources) and operating procedures in general. Regarding collateral valuations, if there are no fresh prices for securities being used as collateral, nobody, including Euroclear Bank, will have a true price. In addition, even when a fresh price exists prior to a far-reaching event of default, such as Lehman Brothers, securities are unlikely to trade at that price post default. It is key for dealers to have a true risk management process in place that will allow them to determine what collateral meets their risk profile, and what haircuts and spreads are required to justify the risks. Euroclear Bank is completely transparent in terms of its pricing sources, quotation ages, i.e. when the price is updated, and in its price collection model.
    For example, prices used by Euroclear Bank are either true prices, quoted by dealers or derived from various real-time and dependable sources, or theoretical prices that are based on sophisticated pricing models or directly purchased from data vendors. As we are transparent about this process, clients can then do their own risk management, excluding certain securities or imposing variable haircuts based on newly defined criteria.

Higgins: Flight to quality is the obvious answer. However, the derivatives market was making headway into a new world of collateral forms under Basel II,  and then during the recent market turmoil reverted to what it knew and trusted well - cash and government bonds. The stock loan and repo markets have been in flux for much of the year, with a move back into equity as fixed income became too expensive to source. There is a direct relationship between the use of collateral and the need to raise high quality assets for use elsewhere.

Little: Basel II has had a massive impact in the way firms are now able to use a wide variety of securities to cover their capital requirements. The greater cost of borrowing cash due to the credit crunch has driven borrowers to demand that lenders take non-cash collateral.

8. Have margins increased and has this had an effect on volumes?

Morosini: In general, haircuts have increased. Some borrowers that consider extra collateral as an unsecured risk towards their counterparty have reduced their outstanding and are not willing to pay for an extra risk. It is not a question of a good name or a bad name. It's just that in front of some repeated demands by many lenders to increase the haircuts - sometimes with no real justification (8 to 10% on a AAA-AA Government Bonds) - most of the borrowers have used all their counterparties and all routes to do an efficient allocation of their best collateral with the lowest possible cost.

Grimonpont: Margins and haircuts have increased as collateral-eligibility criteria has tightened and maturities shortened. Market conditions have led to changes in risk profiles and risk appetites. Allowing collateral management practices to adapt to those changes is a pre-requisite for the market to continue to function. If the market were unable to cater for collateral changes, volumes would have suffered far more than they have.
Higgins:  It is not changes in margins that have effected  lending or financing activity, but rather the banks' risk departments' reluctance to approve lending. Several banks do not have direct access to central bank funding or other sources of general collateral lending which have been seen to be safer in recent months.

Rivett: The increased margins reflect the increased uncertainty in the market  and among lenders and borrowers; this has had a negative impact on the amount of lending and financing occurring in the market.

Little: The long term trend has been growth in volumes and reduction in margin. It's difficult to say whether one has caused the other as there have been many factors involved. This long term trend has been violently interrupted by recent events so that volumes are significantly reduced due to fear and uncertainty.

9. How will the market develop in 2009?

Morosini: We think that the actors and some business structures will change. We hope that unsecured transactions will eventually all be secured (collateralised), which will really emphasise the need for triparty.  In the meantime, we will continue partnering with the authorities and the central bankers to propose services that will bring back some more OTC trading and restore trust. Whether it goes via a CCP or not, it looks like there is an exciting year ahead for triparty providers.

Grimonpont: Collateral, particularly good collateral, will be of paramount importance in the future. This trend is not, as in the past, a result of regulatory initiatives such as Basel II, but from more fundamental reasoning. Collateral is used to protect the collateral holder from the default of its counterparty. This seems very basic, but the market somehow overlooked counterparty risk over time. Market participants now want to know, at any point in time, where the collateral is held, what collateral they hold, when it can be liquidated and at what price. Triparty collateral management service providers are helping dealers with those needs, a trend that I believe will continue to increase significantly in 2009 and beyond. Dealers are likely to reduce their leverage and limit exposures to each other in the foreseeable future, we could expect more of the remaining exposures to be fully collateralised.
    A larger portion of collateral management responsibilities will be outsourced to triparty agents. And we will see a dramatic reduction in unsecured exposures and an improved, but moderate, reduction in overall exposures. Triparty agents will play an increasingly meaningful role in making that happen.

Higgins: We all need a crystal ball for that one! It is hard to get a clear vision in current markets but when things do finally settle down it will be possible to see a clearer path. Regulation and perhaps even greater depth and transparency of reporting is likely to take hold this year. Many more organisations now require good quality data. Wherever and whenever they need it, it will be down to service providers such as The Bank of New York Mellon to ensure clients receive this information and service.
    There are many working groups busily considering what might be best for us all in the years to come, whether derivatives, stock lending or repo. What they are working on will start to influence us in 2009 but has the potential to last a long time.  One thing is very clear, and that is 2009 is going to  be a different collateral management world than before the recent crisis, last month or even yesterday. The pace of change is fast and to be taken advantage of.

Rivett: While collateralised transactions, as a percentage of total activity, will rise in volume, the total activity itself will probably reduce. The increased internal focus on risk for all firms will almost definitely force them to focus on strengthening their balance sheets. The potential introduction of a liquidity risk frameworks shows the direction of regulation. With financial markets and, in particular, the stability of financial institutions proven to be fundamental to a country's economic well-being, there will be a move towards increased transparency and management of 'off-balance sheet' activity. As interest rates begin to approach zero, the spreads available to repo desks will also reduce.

Little: I think we will see a continued preference for secured over unsecured lending. This will fuel an already buoyant collateral market. Firms will be resetting their business strategies and are likely to choose between returning to core banking values or continuing to seek the higher returns promised by aggressive investment strategies. These choices will result in major changes, with some firms exiting parts of the business. But whatever strategy they follow, they are likely to retain collateral management as an important part of the business. No one can afford to leave their collateral assets unmanaged.GSL
    Mark Higgins is Vice President and Head of Business Development for EMEA Collateral Management in the London office of The Bank of New York Mellon. The views expressed herein are those of the author only and may not reflect the views of The Bank of New York Mellon. This does not constitute securities lending advice and it should not be relied upon as such. GSL hosts a debate between Olivier Grimonpont of Euroclear's Collateral Services; Pascal Morosini of Clearstream; Mark Higgins at The Bank of New York Mellon; John Rivett of J.P. Morgan's Securities Collateral Management business; and David Little at Rule Financial.