FINDING A BALANCE
get a return that is equal to or exceeds the contractual return due to the collateral giver. The move away from cash is further illustrated in the securities lending market, with non-cash collateral now representing 60% of collateral received by lenders, according to the ISLA Securities Lending Market Report — September 2015.
While the year-on-year percentage increase may not be considered to be significant, it is expected that this trend will continue into the future, with a growth in the delivery of other securities for collateral, as cash and government securities are used to meet the new regulatory liquidity requirements. These findings are consistent with those emerging from the Deloitte 2014-15 investigation.
The Group of 20 (G-20) mandates that standardised derivatives should be centrally cleared. The move towards the central clearing of all over-the-counter derivatives will generate a rise in the demand for cash, as central counterparties require cash collateral to be posted. The bilateral posting of cash collateral for margining purposes will result in more cash being placed with central counterparties, and thus an overall reduction in the level of cash held by entities.
While the use of noncash collateral may present solutions in addressing the above regulatory constraints, noncash collateral gives rise to its own complexities. These include operational risk arising from the day to day management including the valuation of collateral, monitoring of concentration and wrong way risk, assessment of eligibility criteria, calculation of manufactured dividends-coupons and tracking of the underlying collateral. Furthermore, the use of noncash collateral gives rise to tax consequences, valuation adjustments and funding requirements.
To obtain recognition of the collateral for regulatory purposes, an out-and-out cession of the noncash collateral is required. Under current taxation legislation, such transfers could attract a tax charge (securities transfer tax-capital gains tax which would negatively impact the pricing of these trades. However the recent Taxation Laws Amendment Act, promulgated earlier this year, will provide relief from such tax should certain conditions be met.
The use of noncash collateral gives rise to a number of valuation complexities, in particular funding value adjustments. The latter can be explained as the differential between the cost of financing the transaction and the return received on the transaction. Although relatively new, both the global and local market are still familiarising themselves with this concept and may take some time understanding its application to noncash collateral.
In the short term, this may restrict the market’s utilisation of noncash collateral. Lastly, the receipt of cash collateral provides funding to the receiver, as such cash is fungible and can be used by the receiver to fund the underlying transaction. The receipt of nonfungible (typically viewed as noncash) collateral requires the receiver to raise additional funding to finance the deal and this results in a funding cost to the receiver.
Given the regulatory changes being driven by the G-20, the increased market volatility and the structural holding of assets within the South African market, a change to the status quo in collateral management within the South African financial sector can be expected.
What is clear is that collateral management can no longer be viewed as the routine back office task it once was before the financial crisis.
The use of collateral is a common risk mitigation technique used to reduce credit risk and serves as a means of stabilising the financial system