The policies that came into being as a result of the financial crisis had numerous unintended consequences. Few have caused more sturm und drang than the collateral shortage.
The first effect of Lehman’s collapse was the rush to high quality assets that came from investors gut response to uncertainty. Money managers would rather buy T-bills at zero or negative rates than leave cash with their banks. Collateral supply started to disappear.
Eventually the Fed piled on with QE, ballooning their balance sheet. The paper the Fed bought could be recycled via the SOMA securities lending facility, but as a collateral swap it was a zero sum game. The result was pegging short-term repo rates pretty much at zilch and the Fed, arguably, losing control of short rates.
The IMF estimated that Basel III LCR rules could take $2 to $4 trillion of collateral out of the market. An effort to broaden the types of eligible collateral will help, but not by very much. One is reminded of Ross Perot and the “great sucking sound” quote in the 1992 Presidential debates. Only this time the noise isn’t coming from south of the border.
The push toward central clearing creates even more demand for high quality liquid collateral. Bilateral derivatives trades didn’t always require initial margin, but CCPs do. Non-cleared derivatives will, as per IOSCO, be subject to even higher initial margin requirements.
Some have argued that the supply of high quality liquid assets far outstrips the margin related demand. Government debt is, after all, a growth business. That may be the case, but it doesn’t mean there won’t be logistics problems. Once rates rise and simply giving cash as collateral starts to cost something, it will change the landscape. Collateral transformation for those who need to, essentially, repo out their ineligible paper and borrow paper they can give to CCP, won’t be easy or cheap. Sourcing large chunks of eligible paper to reliably feed the CCPs over long periods of time isn’t a foregone conclusion.
The fall in collateral velocity is a big deal and key to the prospect of collateral shortage. Manmohan Singh, the respected IMF economist who writes a lot on the topic, said in his most recent “Collateral and Monetary Policy”, IMF Working Paper, August, 2013, that velocity has gone from 3.0 at the end of 2007, to 2.5 at the end of 2011, to 2.15 in 2012. Perhaps scarier still Singh found that the numerator of the equation, “Volume of Secured Operations” went from 10 trillion in 2007 to 6 trillion in 2012. That represents a huge drop in flows. If collateral doesn’t turn over and can’t gravitate to its most efficient use, it will be harder to find. Thankfully the FSB’s musings on re-hypothecation were pretty tame. But there are others who think that collateral chains – even those found in repos that are fully collateralized – are dangerous. There is something to be said for complex chains outside of high quality paper being risky – credit intensive paper doesn’t respond well to stress and markets rarely give you a chance to grab more collateral in time.
So what are the lessons learned? Some evidence to the contrary, hopefully it will be that it matters if there are efficient collateral markets. Regulators, legislatures, and central banks have taken on the gargantuan task of making the financial markets less fragile. Complex systems need to be strong, but friction can just as easily bring the most robust machine to a grinding halt. It is important to preserve the lubrication.
A link to Singh’s IMF paper is here.