Scenarios for the Next Collateral Crisis
Finadium
May 2017
Changes to financial rules have been fast and furious including recent modifications to Initial and Variation Margin requirements in OTC derivatives. At the same time, advances in high frequency trading, robo-advisors and passive investing have boosted the growth of new actors with their own directives and rationales. One consequence seems to be a variety of unexpected high volatility events across government bonds and equities. More unexpected consequences are bound to happen.
This research report looks at scenarios for a full-blown collateral crisis that could arise over the next two years. We define a collateral crisis as a situation where the need for collateral or a lack of it locks up the market in some way or creates enough volatility to damage a financial institution to the point of failure. These scenarios are all based on real-world situations occurring now; our projections are predicated on one or more levers being pushed in the wrong direction just enough to make the situation acute.
This report does not say that a crisis is imminent or that the sky is falling. Rather, scenario planning is an important exercise for considering the unknown. By exploring multiple scenarios and how they could play out, financial services firms and regulators can be better prepared to act when an actual crisis occurs. A true crisis may have some elements of our proposed scenarios, and some outside protagonists and impending forces. Thinking through one set of possibilities means that practitioners can be better prepared when variations occur.
This report has been written for a wide range of financial market professionals, from collateral managers looking to ensure that their own business activities are secure to Chief Investment Officers looking to safeguard their investments. Treasury and trading managers should take note in order to spot the signs of an impending crisis. Lastly, regulators, especially Central Banks, should be aware of not only when a crisis may be developing but also their role in creating the conditions for a crisis.
This report is 24 pages with five exhibits.
TABLE OF CONTENTS
■ Executive Summary
■ Where Do Collateral Crises Come From?
■ Illiquidity in US Treasuries
■ A Lack of Credit Intermediation
– Dealers
– Central Banks
– CCPs
■ Other Potential Causes
■ Trading Into the Crisis
■ About the Author
■ About Finadium