An August 22, 2013 article in Bloomberg “EU Said to Weigh Curbs on Collateral Asset Reuse in Repos” by Jim Brunsden & John Glover certainly caught our attention. Quoting from the article:
“…The EU is weighing whether it should limit the length of transaction chains in which traders who receive collateral in turn use the same securities to back separate trades, according to the person, who asked not to be named because the proposals aren’t public. It is also planning measures to make the chains easier to monitor by regulators…”
and
“…Complex” chains of collateral can make it difficult for investors to “identify who owns what, where risk is concentrated and who is exposed to whom,” according to a document prepared by European Commission officials in May and obtained by Bloomberg News. “This has consequences for transparency and financial stability…”
Re-hypothecation is one of those issues that somehow is swept up into the shadow banking is evil debate. Maybe it is because as collateral is moved around, sometimes it can pass through unregulated financial entities (a/k/a the shadow banks). Perhaps it is because collateral chains just sound messy, bringing up visions of “whack a mole” games – now you see it, now you don’t. Of course there are the required references to Lehman (Europe) and the legal ramifications of providing collateral to someone who then has a legal right to re-hypothecate it and what happens when a link in the chain goes bust.
Re-hypothecation allows for several positive things to happen. First, it enables the creation of credit. We have seen economists write about collateral velocity falling, hence taking the capacity to generate credit along with it. If the EU limits collateral chains, by definition this reduces collateral velocity. Most stuff on collateral velocity comes from Manmohan Singh at the IMF and he is doing an excellent job…we wish regulators would actually listen more carefully. Second, re-hypothecation allows for collateral to find its most efficient use. Pushing against that efficiency creates all sorts of friction, which then translate into higher costs, collateral scarcity, lower liquidity, yadda, yadda, yadda.
The article did make a veiled reference to trade repositories. There has been talk of European repo trade repositories for a while. Going past the talk phase would be really good. It is a gargantuan task and will take a while.
We think about how the BIS defined assets that are eligible for Tier 1 in the LCR calculation. From “Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools” January 2013:
“…Active and sizable market: the asset should have active outright sale or repo markets at all times…”
and
“…All assets in the stock should be unencumbered. “Unencumbered” means free of legal, regulatory, contractual or other restrictions on the ability of the bank to liquidate, sell, transfer, or assign the asset…”
and
“…Level 1 assets are limited to… marketable securities representing claims on or guaranteed by sovereigns, central banks, PSEs, the Bank for International Settlements, the International Monetary Fund, the European Central Bank and European Community, or multilateral development banks, and satisfying all of the following conditions… traded in large, deep and active repo or cash markets characterised by a low level of concentration…”
So if a security has reached the end of its re-hypothecation chain, does that means it is no longer LCR eligible? How will anyone actually know? Won’t this put doubt that any security meets the definition of unencumbered? If the regulators want LCR to work, restricting collateral re-hypothecation may not be such a good idea.
A link to the Bloomberg article is here.
A link to the BIS paper on LCR is here.