In a LinkedIn post, Richard Comotto, repo market adviser and co-founder and chief product officer at London Reporting House (LRH), flagged up a potentially growing stream of articles, speeches and studies about the need for more frequent and deeper collateral haircuts, which ultimately may culminate in and eventually be used to justify regulatory action.
One of the papers he examines is “Collateral Damage” from four department heads at the Bank for International Settlements (BIS). The essential thesis is that collateralization fuels aggregate leverage and increases default frequency because it weakens credit discipline and increases the probability of default.
Comotto writes: “The Four Heads see the risk of government bond sell-offs intensifying because of the change in monetary environment. Whereas the period from the mid-1980s to the Covid crisis was marked by cyclical downturns, which led to interest rate cuts that boosted the value of government bonds, this will not happen in the new inflationary environment. Moreover, as discussed in the latest BIS Annual Report, sovereign credit risk is increasing as a result of high public debt ratios and will be subject to secular deterioration because of the cost of the green transition, geopolitical tensions and ageing populations.
“So, HQLA will become less L and occasionally less HQ. Among the policy options offered by the Four Heads are more use of securities as margin in place of cash, the (utopian) Acharya collateral pool insurance scheme, more ‘all-to-all’ trading to relieve pressure on dealer’s balance sheets and higher through-cycle haircuts or minimum haircut floors (but not more central clearing). Watch this space.”