Cash-based collateral dethroned
I
n a world scarred by the events of 2008, considerable
questions have been raised regarding asset safety, the
mitigation of counterparty credit risk, the protection and
use of collateral and greater demands on transparency
within the financial services arena.
New regulations will be enforced to mitigate many of the
risks in the greater market regarding capital adequacy. Basel
III, Solvency II and Regulation 28 of the Pension Funds Act are
examples of these regulations that will place a greater emphasis
on the retention of liquid assets on the balance sheet of South
African financial institutions. This will increase the need to
collateralise financial transactions, forcing banks to retain
greater cash reserves and increase capital adequacy ratios.
The trend globally in response to regulations such as these
has been to rather substitute high-quality liquid securities as
collateral for cash as far as possible. Recent published articles
have alluded to the likely possibility of a shortage of high-quality
eligible collateral, particularly cash, which is the most common
form currently utilised in the South African financial markets.
Collateral is a key risk-management tool used to manage
credit and counterparty risk. It is common to re use collateral
received against other financial exposures. However, the current
bilateral nature brings with it limitations, such as the incomplete
overview of placed and received collateral, as one counterparty
can only “see” their collateral as far as their direct counterpart.
There is often uncertainty relating to the size of the collateral,
where it has been reused and how it can be traced throughout its
movements to the final holder.
The fungible nature of cash used as collateral also brings with
it uncertainty of recovery in the event of financial failure of the
counterparty receiving the collateral.
There are complexities when using securities as collateral,
such as daily collateral calls, corporate actions, manual collateral
substitutions, management of eligibility criteria and collateral
valuations. This can be administratively intensive and the
build-up of collateral silos across financial products also leads
to inefficient use of collateral or over collateralisation. Studies
show that in 2007 global defaults on debt were US$8 billi