To help customers cope with margin burdens, brokers plan to provide services around collateral management and margin financing. But custodians also intend to compete for this buy-side business. In the wake of the raiding of customer segregated accounts by MF Global, and in the absence of clear rules on customer collateral protection, the question of default risk weighs on investment managers entering the swaps clearing game, and some market participants argue that custodians offer the safer option.
Currently, clearinghouses only accept cash for variation margin, according to Judson Baker, product manager for OTC derivatives at Northern Trust. But, “Not every organization sits on a tremendous pile of cash that can be used, and [asset managers] would prefer to use another asset, like a corporate bond,” he says, explaining the need for collateral transformation, or upgrade, services. “As the custodian, we’re facing off against the clearing firm to move margin and to reconcile positions and things of that nature, which is very similar to what custodians do in the futures industry.”
Baker contends that buy-side firms are more comfortable leaving their assets at custodian banks than at broker-dealers. “Custody clients ... want to keep as much of their assets away from the clearing brokers — they want to keep as much of their assets at third-party custodians,” he says. “They don’t see the counterparty risk and the bankruptcy risk [with custodians] that they are seeing with the dealers.”
According to executives at one clearing broker, though, the custodians may be competing with themselves, as collateral transformation was in vogue six months ago. Following MF Global, the CFTC amended Rule 1.25, limiting the ability of brokers to invest client assets in repos, which makes asset transformation more difficult, they say. And more recently, the CME said it would accept corporate bonds as collateral, raising the possibility that firms won’t have to transform their assets.