Manmohan Singh, the IMF economist, has just published a great paper on collateral, “The Changing Collateral Space”. We take a look at what he has to say.
We have always liked Singh’s point of view. His focus on collateral velocity as an important part of markets – providing the lubricant as he says – gives a counterbalance to the critics of re-hypothecation and collateral chains as an evil to be stomped out. But Singh notes that the players and pressures are evolving in the collateral world. New factors like CCPs, the regulatory world of Basel III, and the changing role of the custodians all change the dynamic.
Singh starts with a now familiar refrain on collateral velocity, “…Collateral is like high-powered money where the haircut is the reserve ratio, and the number of re-pledging (the ‘length’ of the collateral chain) is the money multiplier. The aggregate volume of re-pledged collateral reflects both the availability of “source” collateral as well as the re-use rate of source collateral…” The author looks at the “old collateral space”, where hedge funds and sec lenders (on behalf of beneficial owners) supply collateral to dealers and money market funds lend cash versus collateral. The whole process is intermediated by broker/dealers and banks whom efficiently re-use collateral.
“…The ‘new’ collateral space straddles not only the bank/nonbank nexus (where collateral generates a velocity), but other participants who are now significantly impacting collateral availability. The increasing role of central banks, regulations and collateral custodians is significantly changing the collateral landscape. These new dimensions involve (i) some aspects of unconventional monetary policies pursued by advanced economy central banks that remove good collateral from markets to their balance sheet where it is silo-ed; (ii) regulatory demands stemming from Basel III, Dodd Frank, EMIR etc. that will entail building collateral buffers at banks, CCPs etc.; (iii) collateral custodians who are striving to connect with the central security depositories (CSDs) to release collateral from silos; and (iv) net debt issuance from AAA/AA rated issuers…”
The “new collateral space” gets more complicated. There are more players either adding or subtracting massive amounts of collateral from the system. Central banks take collateral out of the market, removing it from the re-use pools and lowering overall collateral velocity. Singh looked at the SNB, noting that their balance sheet has quadrupled since the Swiss franc/Euro peg was created in September 2011. The SNB buys large quantities of Euro debt and those bonds just sit at the bank. As Singh says, “…Silo-ed collateral has zero velocity by definition…”
The Federal Reserve does much the same. “…Since Lehman’s crisis and continuing with the QE efforts, the Fed is housing about $2.5 trillion of “good collateral” (largely U.S. Treasuries and MBS)…” and “…Fed could silo over $1 trillion additional good collateral in 2013 (and beyond, if necessary). This is likely to have first order implications for collateral velocity and global demand/supply of collateral…”
Singh also includes the impact of Basel III, Dodd-Frank, and other regulatory efforts that will remove paper from the system. A combination of LCR requirements and CCP collateral demands (especially non-cleared OTC derivatives) are estimated to remove $2 to $4 trillion of collateral. An easing of collateral requirements and lengthened timetables for implementation will soften the blow, but not eliminate it by any stretch.
The paper also looks at the efforts by Collateral Custodians and Depositories to link central securities depositories (CSDs) and make securities that are otherwise locked away available. “…Preliminary estimates suggest that perhaps up to €1- €1.5 trillion of AAA/AA quality collateral may be unlocked in the medium term via efforts of custodians to optimize collateral and build a collateral highway or global liquidity hub…” Beyond press releases, not much has been written on the efforts of Euroclear, Clearstream and others to unlock the potential of this paper. We applaud the author for making this important point.
Finally, Singh looks at net issuance of debt by AAA/AA countries – adding about $1 trillion of paper to the market annually. “…Database and market contacts suggest that on average about 30%-40% of AAA/AA collateral inventory reaches markets via custodians for re-use (on behalf of reserve managers, SWF, pension, insurers etc.); however, much of the inventory stays with buy and hold investors. So if Debt/GDP remains on trend in developed countries (i.e., the ratio does not increase sizeably), new debt stemming from the “numerator” may provide up to $300-$400 billion per year to the markets assuming counterparty risk especially with European banks does not elevate…”
So what to do? Singh has some policy suggestions on how to improve collateral availability and, in the process, increase collateral velocity. He thinks that central banks like the ECB could do more to lend the “good collateral” they hold. Singh also liked how the Reserve Bank of Australia is dealing with the lack of LCR eligibly collateral. Faced with not enough collateral available for banks to satisfy the LCR, the RBA is providing its own collateral transformation facility, albeit at a penalty rate and haircut.
Singh also noted that changes in the LCR collateral eligibility rules would help ease the “collateral bottleneck”. “…Fine-tuning some regulatory demands will alleviate collateral scarcity in the near term …” He also wrote that allowing netting of non-cleared OTC derivatives exposures by banks has the potential of reducing required collateral from $10 trillion to around $1 trillion.
There are many opinions on whether the collateral shortage predicted will actually occur. Singh’s paper looks at the major factors pushing in each direction. It is worth a read.
A link to the paper is here.