Compared to their US and European peers, institutional investors in Australia have been slow to cover counterparty exposures in derivatives trades by using collateral, reports SIMON MUMME.
For some time now, derivatives trades on both the sellside and buy-side –often including superannuation funds – have been executed without taking collateral into account. Blair Harrison, an executive director of JP Morgan’s financing and market products division, notes that although Europe and the United States recognise the need to conduct two-way collateralisation of derivatives exposures, Australia appears to lag behind. ”In the Australian market it seems derivatives are not collateralised, or they are collateralised unilaterally – which means many of the sell-side traders or the dealers are asking for margin from the buy-side, but the buy side is not asking for margin from the sell side when they’re in-the-money,” Harrison says.
JP Morgan’s pitch to funds is that it will take on the responsibility of verifying, managing and reporting the margin calls made by counterparties, and make margin calls on behalf of the fund to counterparties when the fund is in-the-money, says Michael Davies, a vice president in the bank’s financing and market products unit. “In Australia, a lot of super funds will have swaps, but not collateral because they either do not have a credit support annex (CSA), or they have a unilateral CSA where the sell-side will make a margin call against them,” Davies says. Harrison estimates that 40 per cent of derivatives trades in Australia are not collateralised. But in the US, where many investors were burnt by counterparty failures during the financial crisis, the volume of collateral placed behind trades has increased by about 90 per cent in the past year, Harrison says, reflecting investors’ keener sense of counterparty risks.
Much of this activity has been spurred by the collapse of Lehman Brothers. “In its purest form, collateral is simply an exchange of risk,” Harrison says. “Counterparty exposure, or the possibility of default, stems from legal, operational and settlement risks associated with collateral management.” He says a well-managed collateral program provides a mechanism for controlling such newly exchanged risks, in contrast to the risk of default from counterparties, which cannot be controlled. Crisis capital The crisis triggered a wave of business for collateral managers in the US and Europe, and now a few custodians in Australia are marketing collateral management services that go beyond supervising the pools of assets backing securities lending agreements.