The Bank for International Settlements affiliate, the Committee on the Global Financial System (CGFS), has released a new report on collateral, “Asset encumbrance, financial reform and the demand for collateral assets.” This is an interesting, mostly reasonable read on what regulators and market participants want to know in the collateral management market. We summarize the points that stood out for us.
1) No collateral shortages. While there are certainly greater demands for collateral, and a likely “economic dislocation” of collateral coming, there are no absolute shortages given the US$33 trillion of OECD debt outstanding (we wrote this up in December 2012 in our report on collateral transformation).
2) The CGFS ballparks the amount of new collateral needed at US$4 trillion, including OTC derivatives and Basel III bank capital regulations. This fits in well with outstanding analyst figures. We at Finadium have estimated a shortfall of US$3.6 to 6.7 trillion, and have veered towards the low end of this number following the news that corporate bonds and equities would be acceptable collateral for non-cleared derivatives, and that the full impact of the Liquidity Coverage Ratio wouldn’t hit until 2019.
3) The CGFS mentions the possibility for unexpected consequences due to new collateral needs. An interesting point here is an increase in procyclicality due to all market actors needing the same assets at the same time. We were already aware of the many points of interconnectedness in the financial system that affect and are affected by new collateral demand, including a new importance of securities lending and OTC derivatives collateral. The CGFS also notes that a small number of players in the collateral movement business can lead to greater concentration of risks.
– The CGFS on cliff effects: “Other potentially destabilising dynamics can arise from cliff effects. For example, a particular asset class may become ineligible for margin posting due to a rating downgrade or a tightening of credit standards. This could be the result of close links between bank risk and sovereign risk, or when maturities are concentrated around important regulatory intervals (such as one month for the LCR).”
4) The CGFS is looking at five main policy implications:
– Greater bank transparency in encumbered and unencumbered collateral holdings, requirements and movements. Sure, makes sense. The report includes a good case study of Swedish banks and disclosure of asset encumbrance.
– Including asset encumbrance in the pricing of deposit guarantee programs. Interesting and worth considering.
– Stress tests on collateral encumbrance. A no-brainer. Most readers would have projected this outcome without even looking at the report.
– That Central Banks and regulators “need to closely monitor and oversee” market responses to collateral requirements. An admirable goal that ties in with FSB proposals for trade repositories, the US FSOC’s expanding IT budget and similar trends. We fear however that getting regulators up to speed on the myriad facets of collateral is not a quick task. Effective Central Bank and regulatory oversight of this market is likely many years away at best.
– The most controversial proposal: standardize collateral valuations and haircuts, as per the FSB’s working paper on securities lending and repo. “As standardisation requirements along these lines might be helpful in promoting other asset-backed securities (ABS), authorities may want to explore working with market participants to harmonise collateral standards in market transactions. This would help stabilise bank funding as well as alleviate possible future shortages of collateral assets.” We are not in support of this argument.
5) The CGFS on rehypothecation: “While certain types of rehypothecation can be beneficial to market functioning, if collateral collected to protect against the risk of counterparty default has been rehypothecated, then it may not be readily available in the event of a default. This, in turn, may increase system interconnectedness and procyclicality, and could amplify market stresses. Therefore, when collateral is rehypothecated, it is important to understand under what circumstances and the extent to which the rehypothecation has occurred; or in other words, how long the collateral chain is.”