Market and regulatory reforms are forcing buy side firms to look for new ways of accessing collateral, funding and liquidity, according to a new report from BNY Mellon and PWC.
Based on a survey that 120 buy side respondents with a combined $12 trillion in AUM participated in, the report claims that “access to high-quality collateral, funding and liquidity is not only a pressing concern, but has emerged as the essential new performance driver for the buy side”.
The current challenge with accessing these is twofold. On the one hand, new margin requirements for non-centrally cleared derivatives agreed by the Basel Committee on Banking Supervision (BCBS) and the International Organisation of Securities Commissions (IOSC) will increase buy side collateral obligations.
Indeed, in the survey, 93% of respondents said that they expect new regulations to increase both the amount of margin calls they have and the amount of high quality collateral that they will need to cover them.
On the other hand, it is becoming harder for the sell side to supply liquidity and collateral to the market due to capital and liquidity constraints under Basel III.
“Dealer balance sheet constraints are reducing short-term liquidity and limiting access to transformation trades,” observes the report, noting that this issue is particularly acute for tier two and tier three asset managers, which the survey defines as having between $500 billion to $1 trillion AUM and less than $500 billion AUM, respectively.
Whereas only 15% of tier one asset managers – those with over $1 trillion in AUM – expect to face challenges sourcing short-term liquidity/financing, this figure almost doubles to 29% for tier two and three asset managers.
The problem isn’t a lack of high quality collateral in the market, but rather being able to access it, according to James Slater, head of securities finance and global collateral services at BNY Mellon Markets.
“The buy-side firms reported that there’s a lot of collateral out there, the question is: how to access it? If you’re relying on a bank or a broker-dealer as your primary intermediary into the marketplace then you’re acutely aware now that they don’t have unlimited balance sheet and that they might not be able to intermediate liquidity in the way that they used to, and that’s really been the call to action,” he says.
The report itself actually warns that buy side market participants expressed concern that this inaccessibility of collateral in the financial system could precipitate the next big market stress event.
In response to this “call to action”, the report highlights two different approaches being taken by buy side firms to this problem of sourcing liquidity, funding and collateral.
The first approach is to develop centralised collateral, funding and liquidity functions within their organisations. The fact that 60% of the buy side firms in the survey mentioned plans to move to an integrated model of collateral, funding and liquidity that can operate as an “internal capital market” shows the popularity of this approach.
The second approach being adopted by the buy side is to develop new sources of liquidity, with buy side survey respondents highlighting expanding dealer relationships, engaging non-dealer counterparties, centrally clearing and participating in peer-to-peer platforms as the four liquidity options that they are evaluating.
The report says that buy side firms “are nearly unanimous in their preference for expanding their existing relationships to additional banks/dealers”, but notes that this is only likely to provide marginal benefits as it propagates the challenges that already exist with the current dealer relationship. Meanwhile, it also points out that expanding the number of bank/dealer relationships will likely require a premium as flows have to be continually routed to these new relationships in order to maintain them and secure access to liquidity.
“I think the significance of this survey is that it really confirms the buy-side is taking action in terms of sourcing liquidity, funding and collateral challenges in the new regulatory landscape. And while many of these firms are looking to expand the number of counterparties that they transact with, this study shows that they recognise that it’s not enough to simply add another bank or dealer. As a result, they’re looking at more innovative solutions, like central clearing and peer-to-peer lending through platforms such as DBVX,” comments Slater.
While Slater says that the survey broadly validated his expectations regarding buy-side activity in response to these liquidity, funding and collateral challenges, he confesses to being surprised by the trend amongst hedge funds towards focusing on consolidating their existing dealer relationships.
The survey showed that 79% of hedge funds plan to consolidate their existing dealer relationships, in comparison to 43% that plan to expand them.
Giving his take on these results, Slater observes: “My impression is that there was a period after the financial crisis where hedge funds were diversifying and adding additional primes, but what’s coming out loud and clear in this research is that they are now actually consolidating in order to become more important to their prime brokers.”
The report also notes that more than 70% of hedge funds prefer traditional prime brokerage models and are willing to pay a premium in order to secure balance sheet access.
“Hedge funds have experienced an increase in their cost of funding. These increases range from 35 to 150 basis points based on the size of the fund, the trade flow routed through their prime broker and the investment strategy being pursued,” says the report.