For centuries, scientists and philosophers attempted to turn cheap base
metals into the precious gold and silver used as ancient coinage. Now,
bankers are endeavouring to achieve a Wall Street equivalent.

Known as “collateral transformation”, this new business is emerging as a
rare bright spot in the banking industry. On Wall Street, where new
regulations and competitive pressures have hurt profits, there are hopes it
will boost bank earnings.

Yet collateral transformation – which involves turning relatively risky
assets into ostensibly safer ones – is already capturing the attention of
regulators.

In essence, the banks have found a business opportunity inside the thicket
of new rules designed to make the $640tn derivatives market – which was at
the heart of the financial crisis – less risky. To some financial experts,
it is eerily reminiscent of the slicing and dicing of subprime loans that
helped fuel the financial boom and bust. They worry that the business could
end up hiding risk rather than transforming it – potentially undermining
the purpose of the rules that have helped spur its creation.

Collateral transformation “is exactly the kind of activity where new
regulation could create the potential for rapid growth and where we
therefore need to be especially watchful,” Jeremy Stein, a governor on the
Federal Reserve Board, said last month, the US central bank’s first public
warning about the nascent business.

Yet in the financial industry, collateral transformation is viewed simply
as a tool to comply with new rules. The process involves banks helping
funds pledge their illiquid securities, in exchange for more liquid
collateral which can then be used to back derivatives trades.

“It’s a new cottage industry that’s emerging,” says Supurna VedBrat,
co-head of electronic trading and market structure at BlackRock. She
estimates that her company, the world’s largest asset manager, will need
far more high-quality collateral to comply with the new rules on
derivatives trades. And she is seeking help to meet the growing demand for
good collateral.

Wall Street banks, including Bank of America, Goldman Sachs and JPMorgan
Chase, are ready to assist. The banks plan to create the collateral that
customers such as BlackRock need to back derivatives deals.

At Bank of New York Mellon, Nadine Chakar has for several months been
discussing with clients its new transformation service. The bank – which
specialises in safeguarding trillions of dollars of assets – told its
investors last year that it hopes to offset lower income from its older
businesses with new demand for collateral transformation.

So far, BNY Mellon’s clients – which range from boutique hedge funds to
mega-insurers and asset managers – have been enthusiastic, says Ms Chakar,
executive vice-president of the bank’s global collateral services.

“As we talk to more buyside clients we see that collateral transformation
activities are going to be needed by them,” she says.

Beginning this year, those insurers and asset managers will be required by
many global regulators to run their derivatives trades through so-called
central counterparties (CCPs). This shift to central clearing is the
culmination of almost five years of co-operation between international
watchdogs to clamp down on the products once described as “financial
weapons of mass destruction”.

New rules including Basel III, the Dodd-Frank law in the US, and the
European Markets Infrastructure Regulation (Emir) all mandate the use of
central clearing. The idea, regulators say, is that CCPs stand between the
two sides of a trade, providing a buffer by guaranteeing the derivatives
transaction if one party defaults.

To protect themselves from market turmoil, the CCPs collect collateral, or
“margin”, from the long line of customers who still use derivatives. The
collateral typically comes in the form of government bonds or cash –
securities considered safe enough to protect the clearing house if a
derivatives user were to default.

How much extra collateral will be needed is a subject of hot debate.
Estimates have ranged from $500bn to as much as $10tn. While banks and
traders have been accused of using derivatives, such as credit default
swaps, to bet on the fortunes of other financial entities, thousands of
companies and funds depend on products such as interest rate or currency
swaps.

“We’re talking about new collateral requirements of several trillion but,
in fact, nobody knows because it will depend on a lot of factors,” says
Hélène Virello, head of collateral management at BNP Paribas, the French
investment bank.

For all its alchemic connotations, the process of transforming ineligible
collateral into something accepted by the CCPs is simple, based on
decades-old securities lending and repurchase, or “repo”, desks at the
banks. These desks typically lend out securities – from government bonds to
small-cap stocks – in exchange for cash.

“It’s not a new idea, it’s a new way of packaging,” says Jamie Lake, a
former Goldman Sachs collateral manager who now works at capital markets
consultancy GreySpark. “The transformation business is just going to be
like the repo business.”

In a typical deal, an insurance company might come to a bank with a
portfolio of lower-rated assets such as junk bonds. The bank would lend the
bonds out in the repo market – typically to another big bank – in exchange
for government bonds or cash. The government debt or cash can then be used
as collateral to back the insurer’s centrally cleared derivatives trades.

Like the CCPs, banks providing the service will charge fees and take a
slice of security from their clients in exchange for the transformation.
The collateral comes in the form of a “haircut”, or a clipped portion of
the asset’s market value. “The haircut is basically what equalises
otherwise unequal collateral,” says David Little of Calypso Technology,
which provides clearing software for big banks.

For riskier collateral, such as junk bonds, banks would be expected to hold
back a bigger slice of the asset being transformed. If the value of the
bonds were to fall, the bank would be able to resort to its own collateral
to make the trade whole.

“The haircut may be different from what the CCPs are calling for,” says
Judson Baker at Northern Trust, another custody bank. “It’s going to be
your own proprietary haircut to get you comfortable with the risk of that
particular asset.”

At present there are no reliable estimates of the potential profits for the
banking industry. But Morgan Stanley and consultant Oliver Wyman wrote in a
report last year that revenues from the collateral transformation “are
likely to offset much of those lost” when new regulations kick in that may
inhibit some of the banks’ old moneymaking practices.

“Banks are all gearing up for it but they’re not yet sure whether it’s
going to be a big elephant or a little mouse,” says Mr Little.

But banks also say they are wary of assuming too much risk when providing
the new service. If they load up on too many substandard assets, it could
hurt their own business by consuming big portions of their balance sheets.

Customers may find it easier and cheaper to shuffle their portfolios of
assets to free up eligible collateral. JPMorgan told clients last week that
“optimising” existing collateral would cost a tenth as much as transforming
a three-month US corporate bond into an equivalent US Treasury.

If banks are reluctant or unable to provide all of the transformation
needed by their customers, then other financial entities might step in –
including historically risk-averse lenders such as pension funds.

“Don’t think of all of the transformation occurring on our balance sheet,”
Gerald Hassell, BNY Mellon chief executive, said in response to a recent
question about the risks posed to it by its new transformation business.
“Some of our role is to be an intermediary between parties where we act as
the agent.”

Funds with large portfolios of low-yielding but high-quality securities may
want to eke out extra profits from assets by lending them out. “We might
see new liquidity providers like sovereign wealth funds or well-capitalised
pension funds step in to earn additional yield and provide a portion of
this needed liquidity,” says Mr Baker.

The possibility of new providers of collateral has elicited an unusual
response from some bankers: a warning about potential risks to the
financial system.

“As long as these guys know what they’re doing it won’t introduce more
risk. It will increase the amount of financing activity but not the risk,”
says one senior banker who declined to be named. “But if you get a shadow
group who are providing financing, who don’t understand the risk, and who
aren’t charging the right haircut, then this could introduce more systemic
risk into the financial system.”

The risk is that the new business could create longer and more complicated
chains of collateral, which are more susceptible to vicious feedback loops
when market values start to slide.

Mr Stein, the Fed governor, warned that investors who transform collateral
could end up facing “margin calls”. That means an insurance company that
swapped junk bonds for US Treasuries, for instance, would either have to
stump up more cash to make good on the collateral upgrade or start
unwinding its derivative trade if the value of the bonds began to fall.

Manmohan Singh, an economist at the International Monetary Fund who
specialises in collateral issues, worries that banks may manipulate their
regulatory capital requirements to undertake the activity profitably. That
could mean they were not well insulated if markets crashed.

“You just can’t transform a triple B-rated asset into triple-A without it
costing you,” says Mr Singh. “If banks do this in large sums it will cost
them their risk-weighted assets. That’s something I feel the regulators
will need to be mindful of.”

In the meantime, banks including Barclays, Citigroup, Deutsche Bank and
State Street are preparing to provide the service. A recent Fed survey
shows more than two-thirds of big banks are talking to customers about
collateral transformation. Pension funds also say they are discussing
lending out their safer assets.

Mr Lake adds: “You’re going to end up with this whole industry around the
regulation that may unintentionally make where the risk actually lies less
transparent.”

With additional reporting by Shahien Nasiripour in Washington, Lisa Pollack
in London and Cardiff Garcia in New York.
FT