ESMA warns on collateral costs for institutional investors

ESMA’s latest risk report warns that the introduction of the ECBs public asset purchasing program could reduce the availability of high-quality collateral, potentially resulting in tension in some asset segments in the event of a bear market. The situation is further complicated for UK-based asset managers due to Europe’s sovereign concentration rule, which will require them to diversify collateral across two sovereign bonds, and poses a real challenge for UK-based pension funds, which traditionally only hold Gilts. The report suggests European institutional investors are likely to face higher costs as they source higher-quality collateral for derivatives trades.

The European Securities and Markets Authority (ESMA) has warned of a shortage of high quality collateral in the case of bear market conditions.

ESMA’s latest risk report explained that tensions could rise in some asset class segments as pressure on obtaining high quality collateral, such as government bonds, increases in a bear market.

“Results show that the cost of obtaining high-quality collateral… increases with demand in the cash market from short selling activities, even in calm financial conditions. In bear market conditions – when good collateral is most needed – this may lead to tensions in some asset market segments,” the report said.

The report added the introduction of the European Central Bank’s public asset purchasing programme, as part of the wider quantitative easing programme, could reduce the availability of high quality collateral in the market.

This could mean higher costs for Europe’s institutional investors, which will have to obtain high quality collateral for their cleared and uncleared derivatives trades.

For UK asset managers, accessing collateral such as government bonds in a bear market could be further complicated because of Europe’s sovereign concentration rule, which will require them to diversify their collateral across two sovereign bonds.

The rule is particularly challenging for UK-based pension funds which traditionally only hold UK GILTS and post them as collateral.

“The issue with the Sovereign concentration rules has always been a concern to us,” said Vanaja Indra, market and regulatory reform policy at Insight Investment.

“I can see how for end-users in the Eurozone it makes sense because they have more than one sovereign issuer of government bonds. But not all 27 member states are in the Eurozone.”