Transcript of Question & Answer Session Panel participation at the Global Investor/ISF Australia Securities Finance Masterclass

Good morning everybody one of the questions that I had a lot in the lead up to this conference was why particularly are we having a session on collateral management. We’re used to come along to the ISEP, we’re used to talking about securities lending, but why is collateral management in particular becoming such a topic? The answer is from securities lending perspective and if you’re familiar with securities lending and with REPO you know that all our transactions are collateralised, the type of collateral we take drives our fee, it drives the way we settle and operate and it drives our risk profile. What’s happened though is we’ve not really talked about collateral in detail apart from trends. So what’s changed? Well a couple of things, collateral has really moved to the top of the agenda for many participants in the market for a number of reasons, firstly risk management. So if you think about more and more transactions needing to be collateralised and I think we touched on some of them this morning, but you’ve all been invited you’ve all see a lot of conference on OTC and collateral is really becoming a key topic in regards to how we manage and settle OTC transactions.

Secondly regulations and I think we’ll be speaking a little bit more about that this morning. And finally the need for high quality liquid assets, the term – the discussions on BASAL III and CCPs and term HQLA is becoming much more common. But how does this all lead back to securities lending? Well as you know securities lending is a facilitating transaction, people borrow securities to use them and what we found is there’s been a huge impact to securities lending over the past two years as more and more people seek to find securities that they need to use as collateral. The term collateral upgrades and HQLA will be something that we’ll talk about this morning.

So what’s the current situation in Australia? I’ll use the word provincial because that is a little bit how you find the Australian market as you come into it from outside of Australia. If you look internationally the use of tripartite collateral agents is very mature, it’s main stream. When you come to the Australian market we still very much settle on a bilateral basis, we still use a lot of Australian dollars when we try and collateralise transactions, and the securities lending sector in particular equities, fixed income and cash is quite common but once you move out of the securities financing area it really is Australian dollars, and then as counter parties go internationally they rely on US dollars. A lot of that is just because it’s simple, it’s expensive and it’s really not sustainable when you look at the way the markets are moving going forward.

Internationally the markets have moved and we can use that as a benchmark in regards to how we see the market evolving. But coming back to Australia the change is in the air, it’s really being driven by regulations, it’s still be driven by market changes though, everyone talks about spreads decreasing, there’s been a real shift to focus on risk for the past three or four years, we’re now finding the market shifting back to performance. If you’re owner of long term assets are you generating all the revenue that you can out of those assets. So all of these things are really coming into these discussions around collateral.

We’ve heard expressions around the coming collateral crunch, the coming collateral crisis, what’s going to happen, we’ve heard figures in the billions as to will the market be ready for the physical sheer amount of collateral that’s required especially when you start talking about high quality liquid assets. It’s been interesting though, I mean it may be a question for Mark to kick us off on regulations. As we move towards BASEL III on the 1^st of January this year we saw a lot of speculation about the use of high quality liquid assets in Australia. As a country we don’t issue a lot of national debt, we saw pricing increase for our national debt simply because there wasn’t enough of it in the market and there was a lot of speculation as to what would happen on the 1^st of January. The truth is the market adapted, there wasn’t a crisis on the 1^st of January, pricing stabilised and the market moved on.

As we move towards an environment with OTCs becoming much more collateralised and a phased approach that we’re looking at in terms of implantation, Mark how do you see that playing out in the Australian market?

Well thanks very much for that and good morning everybody. So well I think the focus there on BASEL III is actually quite a good and interesting one. We’re looking at a set of regulations here that are not directly focussed at the securities lending market or the collateral market but they’re going to have a significant impact on the way that market functions. In terms of BASEL III there are a couple of different areas where there is potentially an impact on how collateral markets and securities lending markets function. First of all as part of the reforms banks are going to be required to maintain significantly more capital to support counter party credit risk arising from their off balance sheet exposures, including their securities lending transactions.

And these reforms are going to increase therefore the cost of capital to support the securities lending business. They’re going to have impacts for such activity that is taking place for principal lenders but also for agent lenders that provide indemnities to beneficial owners in their programs. The leverage ratio is another big one here, not here yet but when it does come it could be a binding constraint on securities lending and repo activity for some institutions and this is partly because securities lending and repo are generally accounted for without account taken of offsets to the borrowing from associated collateral. And there are also strict conditions on netting off setting transactions, so the leverage ratio again is going to have implications for how the banks manage their balance sheets and how they manage the capital that they need to support their businesses.

So because of all of this we’re seeing that and probably in many of the institutions represented today there’s a much heavier focus on capital allocation within businesses, there’s a heightened awareness of the costs of individual business lines and as a result pricing in the securities lending market may ultimately change in response to these higher costs. At the same time there may be restructuring of activity to generate efficiencies or scale economies. There may be increased use of centralised infrastructure such as centralised collateral management services or CCPs and we’ll probably touch on some of those aspects later in the panel session.

But one of the other specific elements of BASEL III that Natalie was alluding to there was the liquidity coverage ratio and this is the requirement the banks hold an amount of specified high quality liquid assets sufficient to withstand 30 days of outflows in stressed market conditions and these are the regulations on liquidity that came into force at the beginning of the year.

In the Australian context APRA has defined the liquid assets that need to be held here, these high quality liquid assets or HQLA to comprise reserve balances with the RBA, Commonwealth government securities and semi-government securities. And they’ve determined that the Australian banking system needs to hold more than $400 billion of HQLA to meet the LCR. Now this is a very large amount relative to the outstanding stock of Australian government securities and therefore to require the banks hold this amount would cause significant disruption to the functioning of the market and adversely affect its liquidity. As a result of that the RBA advised that no more than 175 billion of that amount should be met through holdings of government securities or semi-governments. And banks will therefore be able to meet the remainder by accessing a committed liquidity facility or CLF provided by the RBA under which the RBA commits to making available a pre-agreed amount of liquidity under repo against any securities on its eligible list and this extends significantly beyond CGS and semis, this is provided at a fee of 15 basis points.

Even though the CLF is available and even though only a portion of the LCR is going to have to be met with government securities we have seen banks significantly increase the amount of these assets that they hold on their balance sheets and indeed the proportion has risen to about 7 per cent of banks’ total assets from a low of around 1 per cent just at the early part of 2008 pre-crisis. And much of the increase here reflects banks purchases of semi-government securities. So I guess in the context of the point that Natalie was making we’re seeing a very, very significant increase in demand for government securities coming out of the LCR but the RBA has taken steps working with APRA to relieve some of the supply constraints there by making the CLF available and that ought to allow the potential adverse implications for access to collateral assets to be relieved somewhat. Thank you.

Coming back to Australian dollars as cash, I mean it’s interesting I think if you look at the past 10 years particularly prior to the global financial crisis, I don’t say GFC anymore because I understand no one outside of Australia knows what the GFC means, but you know we really saw a shift on the securities financing sector away from cash collateral in many jurisdictions probably the US is an exception to that, towards non cash collateral. If the operational facilities are in place do you see that same shift happening in Australia?

I have a few words on that one. So I think ultimately we are probably heading in that direction ultimately we’ve heard a lot here about centralised collateral management, and I think centralised infrastructure generally can be a significant catalyst for more efficient, more sophisticated use of collateral in the Australian market as it is overseas. I think as both Ash and Lofty have articulated here we are seeing a set of arrangements and a frame work being put in place here through centralised collateral management to allow institutions to find efficiencies in the way they use and mobilise their collateral. At the moment it’s still very, very siloed, there was a report by the Bank for International Settlements Committee on payments and market infrastructure last year that walked through some of the trends in collateral management internationally and the way in which centralised collateral management is halting that. There are different layers of centralisation here, on the one hand there might be arrangements put in place within an institution itself to just get better information about collateral pools in different parts of their business supporting different lines and trying internally to create a virtual pool. But then there are the services that are provided by triparty providers and other collateral management services that actually try to link those pools and mobilise the collateral in a efficient and automated fashion.

And given the regulatory drivers and also drivers in terms of a greater appreciation for the risks in financing arrangements and therefore greater use of secured lending in financial markets generally even if not forcibly driven by regulatory change there will undoubtedly be a greater cost to running many business lines and therefore a greater impetus to seeking out these efficiencies and looking for the opportunities that collateral management in its various guises can actually deliver.

Just in regards to perhaps regulations, I think there’s always the balancing act Mark in regards to you know what the market wants to do and the size of collateral and the requirement for the number of transactions that will have to be required say in two years or three years’ time, when we move to a fully transparent clearing and collateralised environment verse the regulations that are coming into play as to how we collateralise and what type of assets we can and can’t use especially on the regulated fund side. What’s your view on the balance and striking the balance between the two?

So this is an area where there’s been an awful lot of debate internationally, is there sufficient supply out there to meet the quite clearly increasing demands on a pool of eligible collateral assets. And there have been a number of studies that have tried to quantify particularly the demands arising out of LCR and collateralisation of OTC derivatives transactions either through central clearing or non-centrally cleared and these have tendered to look at some quantification of that demand and set it against the outstanding total supply of high quality assets typically government securities in the major markets. In reality there are a lot of nuances to this, probably looking at the total outstanding issuance of government securities is probably not the right measure of supply you need to really do two adjustments I think, one adjustment is in relation to how much of that outstanding supply is truly available for use as collateral, you’ve got to look there at how much is going to be held in buy and hold portfolios that are not going to be price sensitive and are not going to release those securities for use either through lending programs or outright sales of those securities to those that need them for collateral purposes.

And then another big adjustment is required is in relation to the extent to which the remaining active supply can actually be turned over, can there be significant reuse of that collateral. This is what one researcher who’s written a lot on this topic, Manmahan Singh at the IMF, it’s what he calls the financial lubrication role of collateral, getting that collateral circulating through the system to support the needs of the market. And we’ve done a bit of analysis of this in the Australian context, there was a paper back end of last year in the RBA Bulletin where we estimated that the reuse rate of the active supply of collateral assets, government and semi-government securities was around 1.6 times in the Australian market, and that’s really important. There are a number of drivers of re-use here, one pushing it higher is more efficient use of collateral through collateral management services, we’ve heard both. Actually if you talk about reuse within the tripartite arrangements but pushing perhaps back in the other direction is some of this nervousness around re-use where is my collateral going to end up? Can I actually track it appropriately? And from a regulatory perspective the FSB has recommended parameters around rehypothication of client assets and to assist with this transparency point, greater transparency around things like re-use chains and here collateral management services that keep it under the same umbrella can really help with that transparency.

The other driver against pushing in the direction of less re-use is actually things like account segregation within central counterparties and central counter party clearing itself where central counterparties don’t typically re-use. So we’ve got forces in both directions here, I think from my perspective there is a very, very important role to be played by this financial lubrication and we need to ensure that the balance is right and for that regulations that go in the direction of transparency and disclosure are probably more appropriate than those that sort of prohibit and restrict this activity with better information we can management it better from a regulatory and systemic risk perspective.

There’s been a lot of talk about CCPs and maybe transparency from execution all the way through to collateralisation, I know in the Australian market we’ve taken very much a watch and see approach to see what happens internationally, but perhaps and sorry to come back to the RBA view Mark, but you have – there’s been a couple of consultation papers that have discussed or touched on CCP, what’s the general view at the moment from the RBA?

So this is another very live part of the debate and I think there are many in the market place who have noted the potential benefits of an integrated chain of infrastructure that increases both transparency and liquidity of the trading layer, reduces operational risk straight through operational processes all the way from execution through to clearing and settlement and increases collateral efficiency through collateral management. I mean with a CCP potentially in there as well enhances risk management through standardised margining, netting of positions and exposures and potentially also co-ordinated default management. So there are a number of benefits that an integrated chain of centralised infrastructure could potentially bring.

We thought about this recently, you mentioned the consultation there we recently ran a consultation on costs and benefits of repo clearing trying to get industry views on potential costs and benefits particularly in the inter-dealer repo space and this was really triggered by some work that the Financial Stability Board did a couple of years ago. They’ve had a work stream on securities lending and repo which first reported some recommendations in 2013, one of which was that jurisdictions, member jurisdictions of the Financial Stability Board should take a look at whether in their particular jurisdictions there were potential benefits from introducing repo clearing. Now there is repo clearing alive and well and operating very effectively in some jurisdictions in the US, in Europe in particular, we wanted to understand whether industry thought there were potentially similarly benefits in the Australian context. The most detailed response to our consultation came from AFMA which really reflected a survey of a dozen of AFMA’s members and the majority were supportive of central clearing of inter-dealer repos in particular there were comments and views that really reflected this potential for benefit from the integrated chain of infrastructure that I just mentioned a moment ago. They also saw some potential for more sophisticated use of centralised infrastructure in this market to perhaps broaden participation in the repo market and it could deliver not only operational but also risk management benefits. But there were some caveats for the Australian context first of all the participation structure of our market is a bit different to that in others, at the moment there is a relatively concentrated activity in our repo market we’ve just a couple of cash lenders one significant one of which is the RBA, and then there was a little bit of a sense that the size of the market would perhaps make a domestic repo CCP non-commercially viable and that could therefore be an automatic barrier to introducing repo clearing in our market.

At the RBA now we’re taking away the comments from that consultation process and working that up into a consultation response paper hopefully around about September this year and we’ll be engaging with some people in this room and the AFMA committee in the lead up to that. But you know it may well be that if a domestic repo CCP is not going to be commercially viable maybe there are still benefits to be gained from other enhancements with a centralised infrastructure again perhaps around collateral management perhaps around trading platforms for repo clearing and for repo activity. It would be very interesting to hear views from those in the room on whether there are some other potential avenues to achieve the benefits that repo clearing might not otherwise achieve. Thank you.

I just wanted to get the panel’s view on the risk or the apparent risk of accepting equity as collateral in a domestic market as opposed to how that is viewed internationally. Does the panel feel that it’s less prevalent in the Australian market because it’s viewed as a more risky collateral to accept?

And I think in certain transaction types it is already playing a part, so we’ve seen liquid equity included on the list of potentially eligible assets to meet the BCBS IOSCO margining requirements for non-centrally cleared, they’re on that list for market transactions there I think the hair cut is really important there. ASX Clear accepts equity in support of trades cleared for cash equity and equity options and again there with a pretty significant hair cut but nevertheless if those equities are there participants may be quite willing to accept those haircuts, particularly where they are collateralising options in that market and they are going to be natural holders of those particular assets. So I think there is a role to be played in quite a range of market transactions for equity collateral.