The case for investors conducting business on an increasingly secured or collateralised basis only appears to grow stronger and more compelling with each mounting crisis or default in the market. Earlier this year we had AIB and large FX losses. This was followed swiftly by the Enron default.
Traditionally legislation and regulation follow such events to ensure greater control and earlier detection of what are essentially corrupt actions. In the event, measures under discussion in the form of Basel Accord could, indirectly, have softened the impact and extent of such borrower default by rewarding collateralisation. Regulators have long been keen to be seen to be policing and managing the lending process in view of other well publicised bad loans and the latest Basel II Accord manifests this interest – it provides regulatory pressure in its treatment of unsecured versus secured business. In brief, it levies a capital charge on operational risk and any relief on exposures is tied directly to the degree of collateralisation. Unsecured transactions clearly tie up an investor’s capital assets whilst secured does not.
In the aftermath of the Enron collapse and the galloping scourge of ‘Enronitis’ there were serious liquidity issues faced by firms who would normally rely on commercial paper for short-term finance. Demand for such instruments was severely impacted by both debt restructuring in the low rate environment and investor concern over credit quality during such a stressful period. According to Standard & Poor’s, over the past 12 months the US commercial paper market has experienced the sharpest contraction of outstandings in over 40 years. This said, the general commercial paper market is still strong, the US market has shrunk by 12% (some $200bn) and the European market slipped under 5% (some e10bn). The contraction is most marked in the second tier credit rating A2/P2 where demand has shrunk by over 30%. This reflects the heightened concern with regards to credit quality, and whilst things are settling down, many issuers have now experienced the sensitivity of the market and are considering whether they depend too highly on commercial paper investors.
So, given that regulators and investors alike are not looking to prohibit or remove themselves from short term investment opportunities, what are the alternative money market vehicles? Probably the one method most discussed and introduced as the future and safe haven for financing and liquidity reasons is the repo, and more specifically the tri-party repo market.
Long before the Enron saga unwound the financial industry had been experiencing pressure on vital funding and liquidity sources from a more welcome business practice – competition and consolidation. Over the past 10 years the banking sector in particular has seen increased consolidation resulting in the number of firms seeking short term finance reducing and like for like the consolidation of investors has meant that the number of firms providing such finance are shrinking. Either way credit becomes more concentrated and unsecured liquidity is compressed. This also applies to commercial paper as issuer risk becomes more concentrated and diversification harder to achieve.
Given that these indicators appear fundamentally opposed; on the one side there is a drive to secure greater liquidity whilst on the other there is an equally strong desire to diversify and reduce unsecured lending – where is the solution? An alternative, which as a secured vehicle satisfies both drivers and can support short-term cash investment, is a repurchase transaction.
A repurchase agreement or ‘repo’ is widely defined as ‘a secured lending transaction in which one party agrees to sell securities to another party against the transfer of funds, with a simultaneous agreement to repurchase the same securities at a specific price at a later date’. This type of transaction provides the repo rate as reward. This rate, maybe surprisingly for some, traditionally competes favourably with alternative money market strategies of term deposits or buying commercial paper. Though clearly the extent of this will be determined by the types of security or more appropriately termed, collateral accepted – equity collateral attracts a premium over government bonds. The added bonus is not only the offer of a competitive return and a transaction that is a secured investment or loan but by insisting upon a variety of security types as collateral a repo programme can further diversify issuer or security risk. This benefit can however pose a problem to potential investors. So whilst the case for collateralisation is indeed compelling what of the real operating impact of accepting collateral?
Clearly the operational overhead of secured or collateralised transactions is far greater than unsecured arrangements where none exists! Further still the overhead increases determined by the type of security involved, equity collateral earns a higher return but also attracts much higher costs. For many who would consider accepting collateral, it is costly and time-consuming, such that many feel it either prohibits participation in secured transactions or limits acceptance to narrow fixed income collateral only.
To remove this burden a tri-party services provider is inserted between the transaction counterparties. If we consider a repo transaction, the investor and typically collateral provider or borrower agree a financing trade for a given term, rate and collateral profile. It is further agreed that all aspects of the collateralisation process will be the responsibility of an independent third party or tri-party collateral services provider – this is a tri-party repo. The collateral services provider or collateral manager is then responsible for the safekeeping of securities, verifying that securities are eligible as collateral (according to rules specified by the investor), mark to market pricing of all securities to ensure sufficiency throughout a transaction if it is for a term, making calls for extra collateral or returns of any excesses, cross currency valuations and responsibility for all corporate action and settlement activities and full reporting to both parties.
In essence, all operational burdens are transferred from the investor to the collateral manager – secured business becomes as operationally straightforward as unsecured business or buying commercial paper, because for the investor there is no collateralisation overhead and the collateral provider delivers to securities to a specialised securities services provider.
The other important issue to consider is that a repo transaction has the added flexibility of variable maturity. In the US the market is almost exclusively traded on a same day, overnight basis whereas in Europe deals can vary significantly. There is an active market in overnight one day money, but also great demand for one-week, one- month, three-month and even six- and 12-month termed transactions. Whilst it is very clear that the US market has the enviable infrastructure of a single market place, one central settlement agent and highly automated process that enables same day liquidity prized by many, especially the fund management business, Europe can compete. The horizon in Europe is far more fragmented with 12 central security depositaries (CSDs) and over 60 sub-custodians to choose from when settling securities! The tri-party agent, which typically will also have a global custody offering (though this is not essential), can provide collateral services layered over the fragmented settlement environment. By centralising assets within the tri-party agents network, and adopting a pool concept with clear segregation, all movements across clients will be on the books and records of the tri-party agent. Consequently they are not subject to normal market settlement restrictions and tri-party can provide, with the right application, settlement efficiencies and same day, real time collateralisation and liquidity.
One of the most discussed topics in recent years has been the slow adoption of tri-party within Europe and identifying what exactly are the obstacles to widespread use. Many have said that what is missing is a major counterparty default in Europe to wake investors up to the benefits of secured business. Hopefully that will not be required and as the arguments for tri-party become more numerous, compelling and well known.
Shaun Parkes is head of global tri-party services in Deutsche Asset Management in London