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Mobilising collateral – the growing need for counterparty diversification

28 November 2016

Regulatory changes aimed squarely at improving the resilience of financial markets and their participants have had, as an unintended consequence, a direct impact on the pricing and liquidity provided by traditional intermediaries (banks).

Balance sheet costs have risen substantially as significantly more capital is now required to support outstanding transactions. These changes have had a disproportionate effect on low margin, high volume businesses, such as repo, which are balance sheet intensive.

As a result, balance sheets have been scaled back dramatically and consequently banks have reduced their trading operations and risk appetite.

A clear consequence of the reduction and pricing of balance sheets has been a pronounced pass-through of this additional cost from banks to their customers, and a knock on effect on the pricing and liquidity of the underlying assets.

More specifically, spreads offered to clients for balance sheet intensive repo transactions have increased to reflect the additional costs incurred by banks by virtue of regulation – increasing the overall cost of trading.

This has also affected dealers’ ability to market make because the cost of holding and funding inventory has risen.

The demand for initial and variation margin cash and collateral provision/transformation is set to increase dramatically with the adoption of new rules surrounding mandatory margining of uncleared OTC derivatives. Consequently, this has led to question marks around the markets’ current capacity to satisfy the demand for high quality liquid assets (HQLA) and cash during exceptional market conditions.

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