High Line Advisors LLC

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Posts Tagged ‘collateral management

Out of the Shadows: Central Clearing of Repo

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High Line Advisors has published a white paper entitled Out of the Shadows: Central Clearing of Repo – A Transparent Market Structure for Cash Borrowers and Lenders.

“Although personally I am quite content with existing explosives, I feel we must not stand in the path of improvement.” — Winston Churchill

Article at a Glance

Repurchase agreements (repo) are the largest part of the “shadow” banking system: a network of demand deposits that, despite its size, maturity, and general stability, remains vulnerable to investor panic. Just as depositors can make a “run” on a bank, repo lenders can take their money out of the market, thereby denying the lifeblood of cash to broker-dealers (stand-alone or those owned by banks or bank holding companies), which rely on leverage to operate.

The entire shadow banking system has been demonized as a place where loans are hidden within derivatives among nonbank counterparties rather than displayed on the balance sheets of traditional, regulated banks. In reality, the shadow banking system is a legitimate market for secured financing, in which cash is lent in exchange for collateral. Repo in particular has many positive attributes, including disclosure on the balance sheet; nevertheless, the financial crisis exposed several flaws in the secured financing markets in general and repo in specific, and the Federal Reserve System ultimately interceded with liquidity to prevent the further collapse of banks and broker-dealers.

While not categorized as a “derivative,” repo is an over-the-counter (OTC) contract that shares many key characteristics with derivatives, including a reliance on its counterparts to meet obligations over time. The inability of regulators to measure activity in OTC derivatives resulted in the passage of the Dodd-Frank legislation, which requires that certain instruments be moved to a central counterparty clearing house (CCP). As the nexus of all trades, a CCP provides visibility to regulators and credit intermediation for all market participants.

The benefits of central clearing are directly applicable to the repo market and are crucial to the global money markets that are relied on as a safe, short-term investment for individuals and institutions alike. Central clearing is needed to provide lenders with guaranteed return of cash without sensitivity to collateral or credit. A CCP also lays the groundwork for lenders to interact directly with borrowers in a true exchange with transparent pricing.

Central clearing of repo can also provide capital efficiency and more stable funding for banks and broker-dealers. Ultimately, a CCP for repo can evolve into a hub of funding activity for many forms of liquid collateral, thereby bringing the majority of the shadow banking system into full view.

Download a PDF of the article here.

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Collateral Management: Best Practices for Broker-Dealers

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High Line Advisors has published an article entitled Collateral Management: Best Practices for Broker-Dealers. A PDF of the article is available here.

col•lat•er•al (noun)
something pledged as security for repayment of a loan, to be forfeited in the event of a default.

col•lat•er•al dam•age (noun)
used euphemistically to refer to inadvertent casualties among civilians and destruction in civilian areas in the course of military operations. — Oxford American Dictionary

Article at a Glance

Stand-alone broker-dealers, as well as those operating within banks and bank holding companies, face increasing pressure to minimize costs and balance sheet footprint. Collateral management is a set of processes that optimize the use and funding of securities on the balance sheet. For a broker-dealer, sources of collateral include securities purchased outright, as risk positions or derivatives hedges, and securities borrowed. Additional securities are obtained through rehypothecation of customer assets pledged in principal transactions such as repurchase agreements (repo), margin loans, and over-the-counter (OTC) derivatives. This pool of securities is deployed throughout the trading day. At the close of trading, the remaining securities become collateral in a new set of transactions used to raise the cash needed to carry the positions. Poor collateral management leads to excessive operating costs, and, in the extreme, insolvency.

A disciplined trading operation aims to be “self-funding” by borrowing the cash needed to run the business in the secured funding markets rather than relying on corporate treasury and expensive, unsecured sources such as commercial paper and long-term debt. The funding transaction may be with other customers, dealers, or money market funds via tripartite repo. Careful management of the settlement cycle for various transactions allows a broker-dealer to finance the purchase of a security by simultaneously entering into a repo, loan, or swap on the same security or other collateral.

Many aspects of secured funding and collateral management are common to all trading desks. A centralized and coordinated collateral management function supports the implementation of several best practices and provides transparency for control groups and regulators. Regulation and increased dealings with central counterparty clearing arrangements will soon increase capital and cash requirements imposed on broker-dealers. Even in advance of such changes, customers are placing restrictions on the disposition of their assets and limitations on the access granted to broker-dealers. This trend makes it more critical for dealers to optimize their remaining sources of funding.

Note that the prime brokerage area of a bank or broker-dealer is in the best position to manage the collateral pool as a utility on behalf of the entire global markets trading operation. For more detail, see “The Future of Prime Brokerage,” High Line Advisors LLC, 2010. Figure 1 from the article is provided below. A print-quality PDF may be downloaded from our website here.

Collateral Management for Broker-Dealers

Rules of Prime Brokerage Risk Management

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We’ve assembled a list of guiding principals for managing risk in a prime brokerage business, covering the areas where prime brokers are most likely to get into trouble. We encourage the community to contribute to or debate this list. Anonymous contributions may be emailed to feedback@highlineadvisors.com.

  1. Margin Lending: Don’t finance what you don’t trade. If you don’t have price discovery or can’t orchestrate a liquidation of the collateral, don’t make the loan.
  2. Margin Lending: Lend against assets, not credit. The ability to value collateral should be a core competency of any prime broker or repo desk, while expertise in credit extension (unsecured lending) is not. Be aware of the boundary between secured and unsecured risk, as lower margin buffers increase credit exposure in extreme (multi-sigma) market events. If you don’t have possession (custody) of the asset, don’t finance it.
  3. Margin Lending: Finance portfolios, not positions. Diversification of collateral is a significant risk mitigator.
  4. Margin Lending: Accept everything as collateral, but don’t necessarily lend against it. Cover your tail risk with a lien on anything you can get, but don’t add to the problem by lending against less liquid positions.
  5. Margin Lending: Be aware (beware) of crowded trades. The liquidity assumptions used to determine margins may be insufficient when like-minded hedge funds simultaneously become sellers of the stock. This goes beyond positions in custody, but those held by other prime brokers as well. Ownership representations are reasonably required.
  6. Secured Funding: Eliminate arbitrage among similar products. Maintain consistent pricing and contractual terms when borrowing securities or entering into swaps, repos, margin loans, or OTC option combinations with customers.
  7. Customer Collateral: Accept only cash collateral for derivatives. If non-cash collateral is offered, convert it to cash (via repo), apply only the cash value against the requirement, and charge for the cost of the conversion. Cash debits and credits are the best way to manage margin/collateral requirements across multiple products and legal entities.
  8. Contractual Terms: Treat clients that do not permit cross-default or cross-collateralization among accounts as if they were as many distinct clients. If you can’t net or offset client obligations, don’t give margin relief for diversification.
  9. Derivatives Intermediation: Do not provide credit intermediation unless you understand credit risk (again, most prime brokers do not) and charge accordingly. When intermediating derivatives operations, do not inadvertently insulate customers from the credit of their chosen counterparties.
  10. Funding Sources: Raise cash from collateral, not corporate Treasury. Strive to be self-funding, raising cash lent to customers from securities pledged by customers. Practice “agency” lending (from cash raised from customer collateral) over “principal” lending (from unsecured sources of cash, like commercial paper).
  11. Term Funding Commitments: Don’t be the lender of last resort unless you understand what it means, want to do it, and get paid properly for it. Only the largest banks with substantial cash positions under the most dire circumstances may be in a position to offer unconditional term funding commitments. Does any broker-dealer qualify?
  12. Sponsored Access: Have robust controls for high-frequency direct market access, including gateways to enforce trading limits.

Learning From The Past

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“A good scare is worth more to a man than good advice.” Edgar Watson Howe
“That which does not kill us makes us stronger.”
Friedrich Nietzsche

At the end of another full year following the peak of the financial crisis in October of 2008, it may be time to review what should have been learned and to ask whether measures have been taken to improve broker-dealer risk management and operations.Five specific events culminating in the financial crisis contained valuable lessons for stand-alone broker-dealers as well as those at banks and bank holding companies:

  • The self-liquidation of Amaranth Advisors at the end of 2006 was the canary in the coal mine, exposing the difficulty of managing complex customer activity in multiple markets and asset classes, expressed through listed products and OTC contracts in multiple legal entities. Firms had an inadequate picture of aggregate client activity and were uncertain of their contractual rights across the different products. This confusion slowed the movement of cash, creating cracks in the client-broker relationship. Losses at banks were averted solely because of the high degree of liquidity in Amaranth’s portfolio. The crucial question that would haunt banks in the coming months was: what if Amaranth’s remaining positions could not have been sold to raise cash?
  • Several hedge funds, most notably those of Bear Stearns Asset Management, began to default on payments in 2007. Unable to raise cash from increasingly illiquid investments, both investors and banks lost money. The defaults drew attention to financing transactions in which the banks did not have sufficient collateral to cover loans they had extended. It is noteworthy that these trades were not governed by margin policy in prime brokerage, but were executed as repurchase agreements in fixed income, in some cases with no haircut or initial margin. Collateralized lending was practiced inconsistently by different divisions of the same firm, some ignoring collateral altogether and venturing into credit extension.
  • The collapse and sale of the remainder of Bear Stearns in early 2008 highlighted a different liquidity problem: a case in which customer cash held in prime brokerage accounts (“free credits”) significantly exceeded the firm’s own cash position. Because of this imbalance, Bear Stearns was essentially undermined by its own clients as hedge funds withdrew their cash. Once the customer cash was gone, the firm could not replace it fast enough from secured or unsecured sources of its own. Bear Stearns’ predicament forced the prime brokerage industry to confront some hard truths: Because firms had developed a dependency on customer cash and securities in the management of their own balance sheets, sources of cash and their stability were not fully understood even by corporate treasuries.
  • The bankruptcy of Lehman Brothers in September of 2008 exposed the widespread practice of financing an illiquid balance sheet in a decentralized manner with short-term liabilities. Under the assumption that the world was awash in liquidity and ready cash, many firms had neither the systems to manage daily cash balances nor contingencies in the event that short-term funding sources became scarce. The problems of Lehman and its investors were compounded by intra-company transfers and cash trapped in various legal entities.
  • The Madoff scandal that broke the following December was in some ways the last straw for asset owners. Already concerned about the health of the banking system and the idiosyncratic risk of fund selection, they lost confidence in the industry’s infrastructure and controls. Banks now contend with demand for greater asset protection and transparency of information.

In summary, the actions suggested by these five events are as follows:

  1. Aggregate the activities of any one client across all products and legal entities of the bank or broker-dealer
  2. Establish consistent secured lending guidelines across similar products to ensure liquidity
  3. Develop transparency of all sources and uses of cash to minimize reliance on unsecured funding [see Collateral Management: Best Practices for Broker-Dealers]
  4. Match assets and liabilities to term
  5. Prepare for segregation of customer collateral with operations, reporting, and alternative funding sources
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