Now everyone is a repo trader

As our first post of the year, it is appropriate to come back to one of our common threads: collateral. The WSJ article from Dec. 29, 2011 “Europe’s Banks Face Pressure on Collateral” by David Enrich and Sara Schaefer bring up some excellent points about what happens when everyone wants collateral to secure their cash loans: you run out of it. It used to be that banks thought in terms of unsecured borrowing and investment banks saw the funding world through secured glasses. No more. Everyone is now forced to collateralize and everyone is a repo trader.

Banks who use too much of their good collateral find out the hard way when no one wants their dodgy paper (read: Dexia). The ECB has broadened out the collateral they would accept on repos, just in time for the Feb. 29th LTRO 3 year repo. While you might think this is just “lipstick on a pig” in terms of not dealing with the underlying asset quality problem, it does help reduce the risk of sudden funding collapses by lessening the dependence on short term repo markets. Beyond that, Basel III liquidity rules discourage banks from playing the lend long/borrow short game. We can expect there will be less susceptibility to funding shocks as speculative-driven short funding needs shrink. But even if the market for short term collateralized funding doesn’t freeze up, when you run out of collateral to post, the result might as well be the same.

Finadium has written about the impact of CCPs taking massive amounts of high quality collateral out of the system. A link is here.

It is an understatement to say managing collateral is taking on new importance. Traditional silos need to be broken down to enable institutions to look at collateral positions holistically. This is not just a technology problem.  In many shops the equities people barely know what floor the fixed income people sit on (and visa versa), much less how to integrate their systems and manage the flows. For repo desks doing collateral transformation trades (providing their clients with “good” collateral to, say, post to a CCP versus taking in lesser paper), someone on a senior level needs to think about the funding implications. The Bank of England has shown some concern about this too. Many banks go to their Treasury function to sort all this out. But Prime Broker businesses may be in the best position to look across collateral types since they already deal with a broad range of instruments and understand on a practical level how to manage leverage.

So as we launch into 2012, there is a lot to think about. We wish you a happy and healthy New Year.

A link to the WSJ article is here

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