Banks and broker dealers on the sell-side use

and re-use (“rehypothecate”) collateral to

cover their margin requirements with their

counterparties. Margin requirements are

typically driven by stock borrowing, repos,

OTC derivatives, clearing margining and

structured products. Collateral to meet these

margin requirements is sourced either from

the fi rm’s own inventory or from trading

activity with buy-side institutions such

as hedge funds, pension funds, insurers,

corporate or other institutional investors.

Collateral Convergence

Optimizing Effi ciency

Banks and broker-dealers on the sell-side

use and reuse (“rehypothecate”) collateral

to cover their margin requirements with

their counterparties. Margin requirements

are typically driven by stock borrowing,

repos, OTC derivatives, clearing margining

and structured products. Collateral

to meet these margin requirements

is sourced either from the fi rm’s own

inventory or from trading activity with

buy-side institutions such as hedge funds,

pension funds, insurers, corporate or other

institutional investors.

02 Collateral Convergence

Since September 2008, however, there has

been a substantial shift in the landscape of

the marketplace: A significant decrease in

the availability of collateral, largely driven

by market-wide deleveraging in the wake of

the global credit crisis. In a working paper

published last year (WP 11/25), the IMF

estimated that source-side collateral has

declined by as much as $5 trillion.

Alongside the reduction in source collateral

has been a corresponding increase in the

required amount of collateral. This is due to a

number of factors, but principally:

• Strictercollateraleligibility. There has been a

marked movement toward higher-quality collateral

and stricter testing of collateral, e.g., testing for

liquidity.

• Collateralizingpreviouslyuncollateralized

obligations. For example, counterparties that had a

high credit rating must now post collateral against

obligations that previously didn’t require them to post

collateral. Because of credit downgrades or a greater

focus on risk, trades such as uncollateralized OTC

derivatives and intraday credit lines are now often

collateralized.

• Regulatorydrivers. As a result of growing capital

requirements and/or mandatory collateralization,

new regulations in jurisdictions around the world

are focusing on risk mitigation via collateralization.

The clearing of OTC derivatives as mandated by

EMIR and Dodd-Frank will result in a major increase

in the amount of collateral that is required from

market participants. And from a capital requirements

standpoint, there will also be major impact on

collateral demand from BASEL III, Solvency II and

CRD IV.

Optimizing Collateral Efficiency

As with all instances of decreasing supply and rising

demand, the net result is an increase in the cost of

collateral and a drive toward its efficient use. At Citi, we

believe that efficiency in a collateral program may be

achieved by:

• Developing an optimization strategy (e.g., using

the lowest grades of collateral possible), with the

technology and operational capability to support it.

• Overcoming internal organizational silos and a culture

of segregation between trading desks (e.g., fixed

income vs. equity), therefore allowing:

• Centralizing and pooling of collateral and

processes by creating a virtual pool of collateral

across a firm’s entire holdings;

• Collateralizing centrally across all trade/

obligation types by netting obligations where

possible and ensuring that the pool of available

inventory is allocated as efficiently as possible

across a holistic portfolio of obligations.

• Reducing unnecessary buffers, i.e., where collateral is

held in reserve to mitigate late calls, risk of settlement

failure or missing market cutoffs.

• Transforming ineligible collateral for eligible, e.g., via

collateral upgrade or financing trades to “upgrade” to

higher-grade collateral or cash.

• Rehypothecating received collateral where permitted

by the underlying agreement and ensuring that

effective and automated recall management is

implemented.

Collateral Convergence 03

In 2012 and Beyond

Against this backdrop, market participants are facing a

hugely increased demand for collateral against a dwindling

source. In our view, the market will need to converge

toward a model that is:

• Asset-neutral— by leveraging a firm’s entire

inventory of assets across all asset classes, including

collateral that is available for reuse.

• Obligation-neutral — by looking at a firm’s overall

collateral requirements as a whole, rather than by

trade/underlying type.

• Custody-neutral — by ensuring that the asset

inventory held at multiple custodians can be

leveraged without the need for unnecessary

market movements or the maintenance of

inefficient “buffers.”

Besides a change in culture to move toward a centralized

model, a significant investment in technology and

operational expertise is essential to support an overall

collateral optimization strategy.

At Citi, we’ve developed our OpenCollateralSM service

to meet the increasingly complex requirements of

your collateral program and to help you succeed in an

ever-changing marketplace.

Fergus Pery

Global Head of OpenCollateral

Global Transaction Services, Citi

For additional information:

Americas:

Daniel Ulrich

dan.ulrich@citi.com

Europe, Middle East and Africa:

Fergus Pery

fergus.pery@citi.com

Asia Pacific:

Pierre Mengal

pierre.mengal@citi.com

GlobalTransactionServiceswww.transactionservices.citi.com

© 2012 Citibank, N.A. All rights reserved. Citi and Arc Design is a registered service mark of Citigroup Inc. OpenCollateral is a service mark of Citigroup Inc.

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