Should we buy into ESMA’s arguments on collateral shortages?

ESMA published last week their first Trends, Risk, Vulnerabilities report of the year. The report is worth reading for its data points and a view into the thinking of this important European regulator. We take a look at what ESMA had to say about Shadow Banking and collateral, particularly the prospects of upcoming collateral shortages.

– The volume of unsecured interbank lending was around EUR 20 billion at year end 2012, less than half of volumes in August 2007. While the ECB’s lending program has played a role, ESMA sees more traction in secured lending markets than unsecured. Theoretically, we think this bodes ill for LIBOR and Euribor but good for repo indices, but we’ll see how regulators move forward with fixing these unsecured benchmarks over the next six months.

– “EU shadow banking activity contracted by 8% in 2012 while US shadow banking remained stable. European shadow banking amounted to around 18% of EU bank liabilities while the US shadow banking system represented roughly 95% of US bank liabilities.” At 66%, repo remains the largest single component of Shadow Banking that ESMA tracks in the EU. We note with interest ESMA’s working definition for sizing Shadow Banking: “The size of the shadow banking system is assessed by adding the liabilities of ABS issuers and all short term money transactions not backstopped by deposit insurance schemes (repo, MMF, commercial paper and securities lending).” So, no deposit insurance = Shadow Banking? Hmm…

– Collateral supply is up but this may not help reduce collateral shortages in 2013-2014. “While the supply of higher-quality collateral is still estimated to be higher than demand (EUR 11.8tn against EUR 4.1tn in 2012) in Europe, additional demand for collateral is likely to exceed the additional supply of collateral in 2013-2014, making collateral comparatively scarcer.” While we agree with this basic premise, we caution readers to take ESMA’s demand figures with a grain of salt. Like any good projection or analysis, ESMA is basing their conclusions on multiple untested variables. This is a great starting point but ESMA has pulled in so many data points from so many different studies, including ones where we have broken down the methodologies, that we are not confident that their final numerical conclusions are one that should be repeated.

Here are the more interesting parts about ESMA’s supply and demand conversation:

“On the whole there is no shortage of collateral, but rather relative collateral scarcity…. Additional demand for high-quality collateral linked to other factors (such as flight to quality) could exacerbate collateral scarcity.”
We agree entirely as discussed in our December 2012 research report, “Sizing Up the Collateral Transformation Trade.”

“Market participants could use lower-quality assets such as equities or exchange-traded funds.”
But then ESMA is suggesting minimum haircuts and concentration limits, which we disagree with for the most part. ESMA also notes that the volume of liquidity swaps and collateral transformations are very small at present, making the minimum haircut conversation something that will likely be left to the FSB for now.

ESMA brings up rehypothecation (collateral reuse) as a way to ease shortages, but market actors know that this is unrealistic. Collateral Velocity will still go down according to everyone, everywhere.

“Looking ahead, one challenge is to disentangle the increase in demand for collateral due to structural factors such as the regulation of OTC derivatives and Basel III and potential cyclical factors such as the rise in risk perception and the collapse of unsecured markets.”
Well said.

The ESMA report is available here.

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