ENP Newswire -
Release date- 09072014 - Collateral and Liquidity: Striking the Right Balance Mark Manning* Deputy Head of Payments Policy (Financial System).
Good morning. It is a pleasure to address this gathering today and I would like to thank
Regulatory developments and changes in financial institutions' risk preferences are fundamentally altering the way liquidity flows through the system and how institutions fund themselves. These include: the expansion of central counterparty (CCP) clearing; margining of non-centrally cleared derivatives; higher capital charges for uncollateralised exposures; an emerging investor preference for collateralised lending; margin segregation; increasing caution around rehypothecation and re-use of collateral ... The list goes on. Given the experience of the global financial crisis, there are good reasons for all of these changes. At the same time, central banks and other regulators can help to smooth the transition to the eventual new steady state, including by ensuring appropriately measured implementation of new regulations.
An economist at the
But in time these changes seem likely to alter established market practices and reshape incentives. In the remainder of this talk I will discuss some of the key drivers and implications of these changes. I will also highlight where central banks or other regulators' responses could potentially help to strike the right balance.
Increased Demand for High-quality Liquid Assets
Much has already been written on the drivers of increased demand for eligible high-quality liquid assets. In an article co-authored with my colleague
First, new liquidity standards introduced under the Basel III reforms. These standards include minimum requirements for the size and composition of banks' liquid assets: the Liquidity Coverage Ratio. In particular, banks will have to hold sufficient high-quality liquid assets to be able to withstand 30 days of outflows under stressed market conditions. For these purposes, the
Table 1: Australian Banks' Assets
$ billion Share(a) $ billion Share(a) $ billion Share(a)
(a) Share of total Australian dollar assets (per cent), subcomponents are the share of liquid assets
(b) While deposits with other banks are a store of liquidity, they do not contribute to the stock of liquidity held by the banking system as a whole, since the recipient banks will, in turn, need to hold additional liquidity against these deposits; consequently, they are excluded from this table
(d) Includes notes and coins, Australian dollar debt issued by non-residents and securitised assets (excluding self-securitised assets)
Liquid assets(b) 104 7 260 10 306 11
Government securities 10 10 72 28 126 41
Short-term bank paper 54 52 64 24 44 15
Long-term bank paper 9 9 74 29 60 19
Other(d) 30 29 50 19 76 25
Total bank assets 1,582 2,597 2,896
Second, reforms that encourage or mandate CCP clearing of standardised over-the-counter (OTC) derivative trades that require collateralisation of non-centrally cleared trades will significantly increase the demand for collateral.
Collateral agreements in these markets are not new. Since well before the financial crisis, the proportion of non-centrally cleared trades that are subject to collateral agreements has been on the rise. Indeed, the most recent annual margin survey conducted by the
Graph 1: Collateralisation of Bilateral OTC Derivatives
Click to view larger
Agreements to date have typically provided only for the exchange of collateral to cover current mark-to-market exposures; that is, variation margin. Looking ahead, however, OTC derivative trades, whether or not centrally cleared, will also be subject to collateral to cover potential future exposures should a counterparty default and the positions have to be closed out; that is, initial margin.
Initial margin requirements are already beginning to bite - at least among interdealer trades in the more standardised OTC derivative markets, such as that for interest rate derivatives. The majority of outstanding notional value of OTC interest rate derivatives is already centrally cleared and therefore subject to both initial and variation margin requirements. In some jurisdictions, such as
The most widely used CCP in the global OTC interest rate derivative market is the SwapClear service operated by
The transition to central clearing is less advanced in other OTC derivative product classes and with initial margining of non-centrally cleared derivatives not yet widespread the implications for collateral demand have yet to be fully felt on collateral demand. A number of studies have attempted to quantify the likely ultimate effect of both central clearing and initial margining of non-centrally cleared trades. These have reached a variety of conclusions, depending on assumptions around matters such as the volatility of the underlying products and the degree of netting efficiency. Several studies - including Duffie and Zhu (2011) and Heath, Kelly and Manning (2013) - observe that central clearing of multiple products through a single CCP is likely to deliver the greatest netting efficiency and as a result could temper the demand for collateral-eligible assets. Indeed, Duffie, Scheicher and Vuillemey (2014) estimate that central clearing of credit derivatives could reduce collateral demand by almost a third relative to a scenario in which these products remained non-centrally cleared but were subject to initial margin. Anderson and JOeveer (2014), on the other hand, model conditions under which non-centrally cleared arrangements in regional markets could, by accommodating a wider range of local collateral assets, be less costly than clearing through CCPs.
The Australian authorities have closely monitored these developments, paying particular attention to the way regulatory changes are implemented. A case in point is mandatory clearing requirements for OTC derivatives. The regulators recognise the trade-off between the benefits of collateralisation in managing counterparty credit risk and the costs in terms of increased liquidity risk. Acknowledging that some market participants may face liquidity constraints, the regulators favour careful implementation of central clearing requirements. In their latest recommendations to government, the regulators observed that where small financial institutions and especially non-financial entities had restricted access to liquid assets to meet CCPs' initial and variation margin requirements, new sources of risk could emerge (ASIC,
'... for some non-dealers it is unclear whether either the private or public policy benefits will ever be sufficient to offset the costs. Given this, on the basis of currently available information, the Regulators would expect to give close consideration to a specific exclusion from any mandatory clearing obligation for certain non-dealers.' (ASIC,
Similarly, Australian regulators argued internationally for a narrower product scope for mandatory initial margining of non-centrally cleared derivatives that excluded foreign exchange derivatives and the currency component of cross-currency swaps. And, also recognising the limited supply of high-quality Australian dollar-denominated assets eligible to meet the
The fundamental role of collateral is to manage counterparty credit risks in wholesale markets. There are a number of reasons why collateral is an effective tool for this:
Collateral overcomes problems of informational asymmetry; a collateral receiver need only monitor the quality of the collateral, not its counterparty.
Collateral offers pre-funded credit protection, since the collateral receiver has the assets in hand at the time of default.
Secured lending and other forms of collateralisation of exposure overcome difficulties in writing complex contracts that can anticipate all possible market and economic circumstances; legal agreements that underpin collateral arrangements by contrast are relatively simple and can rely on standardised documentation.
Given its role and purpose, collateral typically takes the form of high-quality assets that are subject to limited credit and market risk and easy to monitor. Collateral-eligible assets typically must also be liquid, since in the event of a counterparty default, the holder of collateral will aim to liquidate the assets on a timely basis.
For instance, repurchase agreements - or repos - are typically written on a defined set of high-quality assets. In
The CPSS-IOSCO Principles for Financial Market Infrastructures (the Principles) set international standards for CCPs and other financial market infrastructures (CPSS-IOSCO 2012). The Principles state a clear preference for collateral assets 'with low credit, liquidity and market risks', and set similar expectations around the assets in which a CCP reinvests any cash collateral received. Other assets may be eligible 'if an appropriate haircut is applied'. In the centrally cleared space, some CCPs already accept a relatively wide range of collateral assets to meet margin obligations (Table 2). For instance, in addition to cash and government bonds, CME and Eurex accept various private debt securities. While in most cases, cash and government bonds still predominate, this flexibility is valuable to some participants.
Table 2: Eligible Collateral at a Range of OTC Derivatives CCPs ASX Clear
(Futures) CME Eurex ICE Clear
(a) Various currencies/governments
Sources: CCP websites
Cash(a) ? ? ? ? ?
Government bonds(a) ? ? ? ? ?
Corporate bonds ? ?
Bank bills ?
Mortgage-backed securities ? ?
Money-market fund shares ?
For non-centrally cleared transactions, cash remains the most common form of collateral.
Clearly, there's a balance to be struck. And that's where the central bank comes in. A central bank, uniquely, can use its balance sheet to transform financial assets of differing characteristics into cash balances. One way to increase the potential size of liquidity operations is to expand the set of securities that are eligible for repo to the central bank. Not only does this directly contribute to liquidity, but it also does so indirectly since collateral eligibility criteria in the private sector typically consider the assets that the central bank is willing to accept in its operations. For example, since access to liquidity from the
As previously noted, the
The basic conclusion of a number of recent studies is that there is no globalised shortage of high-quality liquid assets (CGFS 2013). That may well be true today, particularly given the rapid expansion of government debt in most jurisdictions in recent years (Graph 2). However, the focus of most analyses to date has been on outstanding securities issued, rather than the 'effective' supply: that is, the outstanding supply of securities on issue, adjusted to reflect how much is actually available to meet collateral needs. This requires an adjustment for how much is locked away in long-term portfolios and not made available for loan, and a further adjustment for the 'velocity' of collateral. Collateral velocity refers to how many different purposes are satisfied, on average, by re-using a single line of collateral. Most re-use activity is concentrated in securities lending and repo markets. Standard collateral agreements, such as the Credit Support Annexes that support
Graph 2: Government Securities Outstanding
Click to view larger
Kirk et al, researchers from the Federal Reserve Bank of
There are of course important risk considerations associated with rehypothecation and re-use. These were revealed by the severe deleveraging that occurred following the failure of
Looking ahead, some regulatory restrictions on this activity will be introduced, including in the derivative margining regime established by BCBS and IOSCO. And some policymakers favour more wideranging restrictions. While acknowledging the risk considerations, the
Recognising emerging constraints on their collateral, financial institutions are increasingly focusing on how to ensure efficient use of collateral. Many institutions are taking steps to improve the flow of information on collateral holdings across business units and geographical locations, in some cases assisted by third-party collateral management services. We will no doubt hear about some of these in the next session. Many such services also provide tools that assist in optimising collateral use, including by facilitating re-use. These typically apply algorithms that identify the collateral that is cheapest to deliver to meet a particular collateral need, given the collateral receiver's eligibility criteria.
We have also heard a lot about collateral transformation, whereby one party exchanges low-quality or illiquid assets with another for high-quality assets that meet some collateral eligibility criteria. There does not yet appear to be very active use of these services, neither domestically nor internationally, but there remains some prospect that these arrangements will become more important and more widely used over time.
The central bank again has a role to play in improving collateral efficiency. At the time ASX was developing its collateral management service, for example, market participants made it clear that, as a major counterparty in the Australian repo market, the
In its financial stability role and as overseer of key financial market infrastructure, the
In conclusion, the way that collateral is used is changing rapidly. Any interruption to collateral markets, or material decline in their efficiency, could have important implications for the cost of a range of intermediary activities and, more broadly, capital allocation and risk transfer in the financial markets.
Central banks and other financial regulators need to ensure that the implementation of regulation in this space strikes the right balance. In this talk, I have cited the importance of the appropriate exercise of regulatory discretion and a considered approach to implementing regulatory reforms - such as OTC derivative reform and
Thank you for your attention.
I would like to acknowledge the assistance of
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