Clearers use a little collateral thinking

Central counterparties had preferred major currencies, sovereign debt and, increasingly, high-standard corporate bonds. This was due to their abundance and relative liquidity compared with other assets.
Figures from the International Swaps and Derivatives Association show that cash in dollars, euros, sterling and yen made up 82% of all collateral received in 2009. But that is changing.

IntercontinentalExchange, an operator of futures exchanges and over-the-counter derivatives markets, began accepting gold as collateral against energy trades and credit default swaps last week.
Clearing house LCH.Clearnet is also looking into accepting gold, London Metal Exchange warrants and carbon emissions next year as a safeguard in case a trade falls apart.

Chris Jones, head of risk management at LCH.Clearnet, said: "More and more people need collateral for business that is being cleared – but there is only a limited supply of gold around so other solutions will have to be found."

The trick is to know what will work as collateral and what will not.
Some clearing houses already accept warrants issued by the London Metal Exchange that promise to deliver ownership of the metal should the trade collapse.

There is a limit to what can be accepted though. While other sectors of the financial markets, such as trade finance or wealth management, can use assets such as fine wine, cocoa beans or even oil tankers as security on a loan, rapid and complex processing in trading circles precludes many of these options.
Jones said that it was up to the central counterparties to decide what could be taken by examining how easily an asset could be priced and traded, and its ultimate security. He said the demand for collateralising trades would only increase, even when trust returned to the market: "More trades will be collateralised and we will need to find more options to enable it to happen."

Jean-Baptiste Gaudemet, professional services manager at risk management solutions provider Sophis, said: "People still do not trust each other, so the market needs more and more collateral. There is a lack of good-quality assets at the moment, more options need to be found.

We are likely to see more types of collateral being used to cope with increasing demand. He said: "Cash is liquid, but because of this it is costly and there is a limit on using sovereign debt, especially in the current environment."

Figures from the Bank for International Settlements showed that between 1999 and 2009 the amount of collateral in circulation grew at an average annual rate of 35%, while gross credit exposure grew at a 13% rate.

This shows more trades were becoming collateralised over time. This trend accelerated following the fall of Lehman Brothers, which provoked a lack of trust that remains inherent in global markets.
John Rivett, product executive of collateral management at JP Morgan Worldwide Securities Services, a business unit responsible for over $700bn of assets under management, said: "Over the past two years, there has been a more granular focus on mitigating counterparty risk.

"We have always worked with tradable, liquid financial instruments but, recently, we have been investigating other assets, outside of the traditional equity and fixed-income space, that could be used as collateral – we have done a lot of work on gold."

As one of the most favoured assets in good times and in bad, the gold market remains very liquid and the mechanism for pricing it is well established. However, the financial crisis itself has provided another reason for gold to be an ideal candidate for use as collateral.

Rivett said: "Many banks and broker-dealers are holding significant amounts of gold on their balance sheet as an inflation hedge. If they can make these assets work for them as collateral, they see it as a great benefit."
These assets are usually held with a separate custodian rather than in a vault belonging to the one posting the gold, so ownership and margins can be managed on a daily basis by the third party.
Platinum, rhodium and other frequently traded metals may soon also be acceptable.