Whatever happened to the collateral transformation trade? (Part 1 of 2)

Following the events of 2008, numerous regulators across a broad spectrum of financial markets came to a similar conclusion: the use of high quality liquid assets (HQLA) as margin could be an extremely effective tool to mitigate risk and therefore prevent another market crisis. This has led to a vocal conversation about collateral transformation, but where is this trade so far?

Whether it is the increased use of CCPs for repo and potentially securities lending, the creation of a liquidity buffer, tri-party reform, the margining of forward trades or the migration of OTC derivatives trading to exchanges, all of these reforms have at their center a requirement for high quality liquid assets to be held as a key means of risk reduction.

Of these, the broader market immediately focused on the reform of derivatives trading as having the greatest potential to increase demand for HQLA. With the total notional value of OTC derivatives contracts estimated at $693 trillion (BIS semi-annual survey June 2013) the market concluded that the migration of a majority of these contracts to an exchange would generate an enormous demand for HQLA to support initial margin requirements. Although estimates ranged from $1 trillion to even as high as $20 trillion, a consensus emerged around 2010 or 2011 that $2 trillion of HQLAs would have to be mobilized to satisfy this new requirement.

No sooner did this consensus emerge than the repo and securities lending market began to question where this incremental collateral would come from. Globally, the total value of sovereign securities available for loan is currently $2 trillion including approximately $535 billion already on loan, according to DataLend. Numerous articles and more than a few panel discussions at repo and sec lending conferences speculated about the impending collateral shortage.

Surprisingly, most commentators expressed a fear that this would have a tremendous negative impact on the global repo markets. Almost none viewed this potential pickup in demand in the moribund US treasury and repo market as the savior of that market which was then mired in a sub 25 basis point interest rate environment with the Fed supplying virtually unlimited loans from their SOMA holdings at 5 basis points. You would have thought that at least a few individuals would have seen this potential jump in demand as the equivalent of the full employment act for repo traders.

To be continued…

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Teeth-gritting selections from the latest CPSS-IOSCO comment letters on CCPs
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Whatever happened to the collateral transformation trade? (Part 2 of 2, Finadium subscribers only)

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