April 26, 2012

Is Bond market liquidity the achilles heel of Clearing?

This article was written by Richard Ellis from Sapient Global Markets, and brings a focus to the issue of Bond market liquidity and collateral transformation.


According to a survey by Rule Financial, 90% of sell-side firms intend to offer Collateral Transformation services. Have the unintended consequences of putting the Repo market between the buy-side and CCPs been fully considered? In this article I consider the how collateral transformation will react in a stressed market and the consequences of liquidity risks, and rehypothecation, as key dangers in the new OTC ecosystem.

The third party clearing structure

Both the Dodd Frank Act and EMIR mandate that all swaps traded by Swap Dealers and Major Swap Participants that are eligible must be cleared. As of January 2012 LCH.Clearnet the worlds biggest IRS OTC clearing house has 48 members whilst the proposed Dodd-Frank regulations would impact all of the 822 ISDA swap dealing institutions. A constant bone of contention since the regulations were proposed is that the majority of the market does not meet the clearing houses’ membership requirements and although regulators have discussed forcing CCPs to lower membership requirements, the increase in risk to the clearing house would be too great. The refusal to lower membership requirements will drive parts of the swaps market into a third party ‘client’ clearing relationship. Some institutions may prefer a client clearing relationship to direct membership as the volumes traded in clearable instruments may not be large enough to justify the costs and responsibilities of directly joining a CCP. Client clearing provides exemptions for the client from the responsibilities of the clearing houses default management processes and pledging money into the default fund. In a client clearing relationship a Fund executes a trade with a Bank and the Fund uses an FCM as an intermediary to route it’s trade to the CCP. For the life of the trade in the US model the Fund faces the FCM under a client clearing agreement. Under the European clearing model the intermediary is a Derivatives Clearing Member (DCM). For the remainder of this article I will refer to the intermediary as an FCM, for simplicity, with repeating the FCM/DCM nomenclature.

Why is transformation needed?

One service offering that has arisen from the indirect clearing relationship is collateral transformation for the FCM to finance the margin calls for variation and initial margin received from the CCPs. Collateral transformation is the process of upgrading collateral, most commonly achieved by the client pledging corporate bonds to an FCM who will perform a repo transaction to switch the bonds for cash and pledge the cash to the CCP to cover margin. The client pays a fee to member for providing this service. Collateral transformation however increases a number of risks elsewhere, covered in articles such as Smoke & Mirrors.

Increased liquidity risk via the Repo market

Many buy side firms in particular have raised their concerns about their ability to pledge eligible collateral for CCP initial margin calls, delivered in bonds. For example pension funds invest in securities with long dated maturities to match the liabilities of the pensions they pay out. Having to withhold a portion of the assets of the fund to buy eligible collateral for a clearinghouse will detract from the performance of the fund. If the fund does not possess eligible securities it will have to or buy / borrow assets which will require an expertise outside of the investment fund’s mandate or trading in a market the fund does not have access to, thus reasons why they may choose to use a collateral transformation service, rather than transform the assets themselves. The collateral transformation service would appear appropriate under normal market conditions, however as markets become stressed the FCM has the right to refuse to fund the margin call completely or use a number of techniques to reduce their risk. These can include:

  • Increasing haircuts on bond pledges
  • Reducing bond eligibility
  • Refusing to accept new business

This can cause a significant spike in the funding requirements of a transformation service user to fund its positions and the implications can be severe. The demand for high quality collateral can drive up the price of eligible assets and squeeze the market. The refusal by the FCM to accept lower quality collateral for the repo’s will force a sale of ineligible assets to raise cash further driving down the assets price. There will be a break even point for each trade where the financing cost forces the termination of all cleared positions to prevent the client receiving a margin call that cannot be met.

Funding Squeeze Example

  • Portfolio Aggregate Notional Size: $100m
  • Hypothetical Variation Margin Requirement: $10m

The pension fund performs a repo selling 11.75m of a Corporate Bond trading at 0.95 with an 11% haircut to receive cash of $10m to cover the margin:

  • 11,750,000 x 0.95 / 1.11 = $10,056,306.31

In a distressed market the Corporate Bond is now trading at 0.75 and the haircut has been increased by the FCM to 15%. A notional of 15.4m is now required to fund the trade.

  • 15,400,000 x 0.75 / 1.15 = $10,043,478.26

If the increase in securities to cover a margin requirement is replicated across all trades on the swap portfolio the amount of securities required to fund margin increases significantly, therefore a choice must be made:

  • Borrow cash and pledge unsecured which is expensive and has a large opportunity cost
  • Borrow cash and perform a reverse repo to bring in more bonds that can be repo’d out to lower the funding cost of the cash

Either option requires the firm to increase its leverage and stretch its balance sheet in the hope that the market stabilises before credit lines are cut off.


As the figure above indicates, the flow of assets in collateral transformation and ultimately the margin pledge can be complicated. Understanding which leg(s) of the transaction comes under which legal framework also needs care. This is an important differentiation in order to understand the rights the client has to the original asset in the event of an FCM default. The collateral transformation may be performed under a Global Master Repurchase Agreement (GMRA) meaning the bond sold in return for cash would not be required to be segregated from the FCMs assets and the FCM would then rehypothecate the bond by performing a reverse repo to sell the bond to the market. The cash raised from the collateral pledge would be covered under the FCMs clearing agreement ensuring it was segregated from house assets. US legislation (SEC Rule 15c3-3) limits the amount of rehypothecation that the FCM can perform ensuring the FCM does not stretch its balance sheet beyond capacity. The UK has no statutory limits for rehypothecating collateral. The merry-go-round of rehypothecation and understanding exactly where assets lie in the event of a default is a headache still being felt by MF Global’s clients. Even if assets are pledged to a US entity it is not yet forbidden to transfer them to a UK subsidiary to take advantage of the more generous rehypothecation rights, as shown in the diagram below. In the defaults of both Lehman and MF Global this is a distinction many clients have fallen victim to.


FCM clients require access to CCP eligible collateral therefore collateral transformation is a solution to this need that creates a dependency on the short term repo market. As Lehman Brothers found out, when the repo market seizes up, haircuts are increased and bond eligibility accepted by repo counterparties can change significantly and quickly. Counterparts will only accept the most credit worthy collateral for the repo trade halting the access to the funds required for the CCP margin. The sharp increase in funding requirements to meet margin demands can result in the default of a firm if the assets are not readily available. FCM clients must be cautious and take steps to ensure collateral transformation will be provided in a stressed market. If the FCM reduces the bond eligibility it will transform only the most credit worthy bonds, the client will find itself in the position of not having access to eligible collateral and unable to meet margin calls from the FCM.

Access to eligible collateral has different challenges and impacts for each institution managing credit risk:


  • Liquidity – Access to eligible collateral in sufficient quantities in a distressed market in order to meet margin calls
  • Rehypothecation – Understanding how an FCM will manage the assets pledged to them either under the repo transaction or client clearing agreement is vital. This distinction will relate to both the segregation of assets and the rehypothecation rights


  • Client Service – Intermediaries must manage the credit risk with the client including setting appropriate credit lines for providing collateral transformation in a distressed market.


  • Collateral quality – With the increase in trades being sent to the CCP the increased collateral demands from the CCP may require the CCP to lower its collateral standards as there may not be enough eligible collateral in the market to meet the requirement. This would ultimately raise the risk profile of the CCP, as the CCP has mutualised the risk in the market, ultimately the systemic risk is increased.

The government bailouts in 2008-2009 demonstrated what happens when insufficient capital levels are maintained with only a small percentage of the OTC market begin centrally cleared. By increasing the volume of trades cleared this will significantly raise the level of capital required to cover the resulting liabilities. As clearing grows access to liquid collateral must be seen as a key component in managing systemic risk in the market by regulators – after all, is the new swaps eco-system any more stable than the one we have now?

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