What Makes for a Good Collateral Asset?
By Greg Muecke, Head of Product Management at Tradewind Markets
Throughout history, borrowers and lenders have created incentives through collateral, ranging from kings’ crowns in Medieval Europe to wheels of cheese in present day Italy. While crowns and cheese may be fit for purpose, few would argue these make for good collateral assets in the regulated international capital markets of today.
Today, these markets prefer high quality liquid assets (HQLA), with the most popular forms being government bonds and equities. As regulatory and market forces drive further demand for collateral, we can learn from the past and apply technology available today to answer fundamental questions about an asset such as “Who owns it?” and “Where is it?”, unlocking the ability to deploy underutilized collateral assets. But what makes for a good collateral asset?
Characteristics of a Good Collateral Asset
A good collateral asset should be cost-effective to hold, operationally easy to use, and easy to take delivery of and to liquidate. Falling short on any one of these attributes inhibits the effectiveness of the collateral. Underpinning these attributes, the systems used to manage good collateral assets need secure, central, digital ownership records with transparent data and collateral status. Such digital ownership records allow for the real-time flow of information and integrations with other core market infrastructure required by regulated international capital markets.
As innovations come to market, we see expanded opportunities to deploy good collateral assets effectively.
The King’s Crown
In 1339, King Edward III pledged his crown to a lender in Luxembourg to finance the Hundred Years’ War. While it was easy to answer the questions of “Who owns it?” and “What is it?”, the operational complexity in managing the collateral likely made the prospect of converting to cash daunting. The journey by land, sea, and land yet again to take possession of the crown is a far cry from the “easy to take delivery or liquidate” criterion of a good collateral asset.
Wheels of Cheese
In present-day Italy, golden wheels of Parmesan cheese are eligible collateral for Italian lenders. With storage in a third-party warehouse, the lender has the confidence that they can take possession of the premium cheese in the event of default. However, it is unlikely that the asset can be liquidated promptly for cash. The ownership records systems for cheese are unlikely to have the level of integration with international financial institutions required for a good collateral asset, and such integrations enable the prompt liquidation for cash.
Learning From Mistakes
At the height of the 2008 financial crisis, basic shortcomings in financial market infrastructure contributed to market uncertainty. In the case of Lehman Brothers, a large U.S. financial institution that filed for bankruptcy, transferring certain client assets became difficult in part due to a lack of easily accessible records that could answer basic questions like who owned an asset and where it was. Because the paper trail was so convoluted, tracing these records back made for a lengthy recovery process. So while the collateral assets themselves satisfied several of the good collateral asset criteria, system infrastructure did not facilitate the smooth operational transfer of those assets. This ultimately resulted in collateral givers being subject to a lengthy and costly recovery process.
Despite its broad acceptance as a safe haven asset and trading volume measured in the trillions of U.S. dollars per year, gold’s use as collateral is a fraction of that of government bonds and equities. A main driver has been the lack of digital ownership records that allow the separation of the value of gold from its physical location. Without such digital ownership records, it is necessary to ship gold, making physical gold logistically challenging to transport. So while gold may satisfy many of the attributes required for good collateral (it can, for example, be easily sold with little to no loss of value), the market continues to miss opportunities to deploy gold as collateral. Seven hundred years later, lenders still face the same issue they faced in 14th century England: physically moving metal around the globe is time-consuming and costly.
As an example of a missed opportunity, take the gold market activity in March 2020. As investors sought to increase cash positions, many gold investors liquidated their gold holdings for cash only to re-establish gold positions weeks later. Without operationally efficient ways to post gold as collateral to raise cash, many gold investors incurred what would otherwise be unnecessary transaction costs.
Today, however, technology has made it possible to digitize many of the processes that deter the use of gold as collateral. Digital ownership of physical gold has become increasingly popular and allows borrowers to hold an electronic record of title of physical gold stored in a secure location. This lets borrowers effectively prove their ownership of the metal without the logistical hassle of physically moving the gold.
The 2008 financial crisis has been the catalyst for a number of regulatory reforms that are helping improve how international capital markets use collateral. The Basel Committee on Banking Supervision (BCBS) has created a regulatory framework that sets standards and establishes confidence for the use of traditional forms of collateral such as government securities.
As seen throughout history, collateral use continues to evolve in unexpected yet valuable ways. By learning from history and applying technology available today, market participants can continue to evolve how they deploy good collateral assets.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.