March 20 (IFR) - A financial transaction tax (FTT) proposed by the European Commission could unleash a collateral crunch as much of the US$639trn over-the-counter derivatives market shifts to central clearing.
Plans to slap a 0.1% levy on stock and bond transactions and 0.01% on derivatives could raise as much as EUR35bn each year. But the unintended consequences could pose a problem for implementation of the swaps clearing mandate that forms the backbone of the European Markets and Infrastructure Regulation (EMIR).
Repo is set to play an important role in the rising demand for high-quality collateral by delivering cash in return for assets that cannot be posted at clearing houses.
“The FTT proposals put at risk the implementation of EMIR,” said Godfried De Vidts of the International Capital Market Association (ICMA), an industry lobbying group.
“If the FTT on repo transactions (which facilitate collateral being available where it is needed) goes ahead, the regulatory collateral crunch will actually materialise. Is that what we really want to happen?”
The latest statistics from ICMA show repo activity is already shrinking due to the LTRO effect. At EUR5.6trn as of December 2012, outstanding European repo business was 10% down from a year previously.
And while clearing houses themselves will be exempt from the tax, investors could incur the charge for simply posting their collateral at a clearing house.
“It could drastically reduce the mobility of collateral, and drastically increase transformation costs, making collateral more inefficient from a mobility perspective. We don’t believe it is the intention of the proposal, but it is one of the unintended consequences,” said Staffan Ahlner, managing director, global collateral management at BNY Mellon.
“Variation margin is typically required in cash, so you’re asking fund managers to hold vast amounts of cash liquidity to meet variation margin calls that are determined by factors they can’t control, such as moves in interest rates,” he said.
“Without the ability to transform collateral, we are then looking at a situation where fund managers may have to hold large parts of their portfolios in cash to meet such margin call.”
Some believe that the importance of transformation may have been overplayed as a solution to the collateral gap given the potentially costly nature of the service.
“My guess is that collateral transformation will be fairly expensive anyway, so it’s likely that any increase stemming from a transaction tax is likely to be small compared to the overall cost,” said Ted Leveroni, executive director, strategy at post-trade processing firm Omgeo.
“The problem is that there’s not that much supply out there. There might be a lot of US debt outstanding, but the majority of that is held by the US Fed and sovereign wealth funds - and they don’t want those assets loaned out to a hedge fund unless the bank provides a guarantee. And that uses up balance sheet for which the bank has to charge upwards.”
Ultimately, the impact depends on the magnitude of a shortfall. Studies put the additional collateral requirement associated with derivatives clearing at anything from US$100bn to US$2.6trn.
“No one knows how big the collateral shortfall is, and in reality it doesn’t really matter what the number is as it’s not evenly applied. If you are a government bond fund and the shortfall is large, you won’t be hit too hard, but if you’re a long-only equity shop, even a small shortfall will hurt as it will fall mostly on you,” said Leveroni.
As a Bank of England study highlights, the real figure is largely dependent on the netting impact.
“The collateral shortfall question is complicated,” said David Little, a director at Calypso, a firm that provides risk management systems to clearing houses and other market participants.
“The Bank of England estimate was significant for identifying the importance of netting efficiency to calculate the final number. The problem is, no one knows what netting efficiencies will be, and there’s a danger there will be a significant amount of portfolio fragmentation due to multiple CCPs.”
Ultimately, increased collateral demand will be addressed by a range of solutions including optimisation and a broadening of acceptable collateral. Eurex is one of the few clearing houses making the shift to equities, accepting a range of EuroStoxx 50 and DAX stocks as part of its buyside clearing service.
“I expect more CCPs accept equities in a controlled way. Many are tied to an exchange - if and when LSE acquires LCH.Clearnet, for instance, accepting highly liquid UK equities seems sensible,” said Little.
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