Sovereign Wealth and Pensions Enticed by Collateral and CP Business

Posted on 04/13/2015

sovereign wealth fund collateral

With expanded capital restrictions, especially when it comes to derivatives, traditional banking institutions are dealing with tighter balance sheets. The European Market Infrastructure Regulation (EMIR) and U.S. Dodd-Frank Act have modified the requirements for clearing and collateral. These laws promote the central clearing of standardized over-the-counter (OTC) derivatives contracts. The forced move toward central clearing is feeding a manufactured hunger for more high-quality securities to be used as collateral. Another source of collateral besides banks are sovereign wealth funds and pensions, many which possess massive inventories of high-quality securities. These asset owners are becoming sources of liquidity and typically search for yield opportunities any way they can.

Links between banks and non-banks would become further blurred.

Tail Risk Capital for Counterparties

In late March, the California Public Employees’ Retirement System (CalPERS) finalized a deal in which the pension giant partnered with agency securities lending provider eSecLending LLC to make a 1-year repurchase (repo) facility. CalPERS gets paid for backing the repo facility, enhancing the system’s cash return. Essentially, CalPERS and eSecLending would provide Chicago-based Options Clearing Corporation (OCC) a cash draw from CalPERS if a counterparty defaults on a derivative trade. OCC is serious on diversifying its liquidity base which traditionally relied on large banking institutions. John Fennell, Executive Vice President of Financial Risk Management at OCC explains how these arrangements enhance cash returns, “For the fund, they are able to invest in short-term investment funds on an overnight basis while earning a commitment fee from the borrower of the funds. If the lines are ultimately drawn on, the fund earns a higher rate to compensate for the inability to invest the funds overnight.”

Sovereign wealth funds, an institutional investor market surpassing US$ 7 trillion in assets, are a natural source of capital for these types of arrangements. Fennell adds, “I think the aspect of pension funds that makes them attractive to central counterparties is their cash flows that are controlled and not susceptible to runs by clients during times of crisis. Sovereign wealth funds have very similar characteristics which would presumably make them a great alternative for this type of investment. Also, given the size of sovereign wealth funds, this could add a material inventory to the liquidity supply that might be accessible to central counterparties.”

On the one hand, these mammoth-sized pensions possess the risk tolerance and balance sheet capability to supply trading liquidity to bond markets. These assets owners could face competition risk in the sense that big banks have built trading expertise over decades, privy to many sources of data, have greater flexibility in compensation plans and market infrastructure. Pensions could form separate entities to get involved in these activities, but then they would be regulated similar to other firms in the business.

Collateral Transformation Business

Institutional investors like sovereign funds have been investigating ways to profit from the expanding desire for high-quality collateral. Another course for wealth funds and pensions to profit is collateral transformation. There are different ways to achieve collateral transformation. This process involves someone from the buy-side needing to post collateral for a derivatives trade at a clearing house. In some circumstances, the asset manager doesn’t have enough high-quality securities like Treasuries and must swap in order to move forward. In this case, a bank or asset owner levies a fee to compensate for taking a risk on swapping assets. A number of sovereign funds like Norway’s sovereign wealth fund are exploring strategies with their custodial banks to enhance returns in fixed income.

New regulations are fostering an environment for a potential collateral squeeze. A squeeze that would stimulate further action by sovereign wealth funds and pensions on entering the collateral transformation market. However, wealth funds are cautious on earnings fees by trading safe, liquid assets on their balance sheets for riskier ones. A black swan event would be devastating for wealth funds partaking in these “risk-on” activities. All in all, as sovereign wealth funds and pensions become greater providers of liquidity to capital markets, new linkages could be formed that would fuel a possible market contagion. Links between banks and non-banks would become further blurred.

Get News, People, and Transactions, Delivered to Your Inbox