Manmohan Singh from the IMF is out with a new paper that tries to explain what is driving collateral use.
Izzy has already done the heavy lifting on the paper and presentation, but the paper is quite good so here’s a quick overview from me. Basically, there are four main causes that affect the collateral market:
Although there are many new “entrants” and develpments in the collateral space, we highlight the four salient ones which in our view will have a non-trivial impact on the collateral dynamics. These are (i) central banks that remove good collateral from markets to their balance sheet where it is silo-ed; (ii) regulatory demands stemming from Basel III, Dodd Frank, EMIR etc that will entail building collateral buffers at banks, CCPs etc; (iii) collateral custodians who are striving to connect with the central security depositories (CSDs) to release collateral from silos; and (iv) net debt issuance from AAA/AA rated issuers.
First, central banks. Let’s use the SNB as an example:
Despite European Central Bank’s efforts to keep the ratio of good/bad collateral high in the EU financial markets, actions of SNB (and other central banks) are diluting this objective. Since the Swiss franc/€ peg in September 2011, the SNB balance sheet has quadrupled to about € 430 billion. The bulk of assets now comprise short tenor “core” € bonds (and lately UK gilts and US Treasuries). This reflects prudent asset-liability management at the SNB. However SNB’s bond purchases withdraw the best and most liquid collateral from the Eurozone; this reduces the collateral reuse rate since these bonds are silo-ed at SNB and not pledged in the financial markets. Silo-ed collateral has zero velocity by definition. Market sources indicate that lately long tenor € bonds also being purchased by SNB since there is limited supply of short tenor € bonds. Market sources also indicate that other central banks have also been buying core € bonds as part of their reserve management strategy; this again silos good € bonds and dilutes ECB’s efforts. Not surprisingly ECB’s next steps have been to expand collateral eligibility that includes lowering the asset based securities threshold, and relaxing the foreign-exchange collateral requirement (i.e., non-€ collateral is eligible).
It is the same with other QE-conducting central banks. They take good collateral out of the system and store it in “silos” so it can’t be used. The Fed is housing around $2.5 trillion of “good collateral” (largely U.S. Treasuries and MBS) — and, as Singh says, “at this rate Fed could silo over $1 trillion additional good collateral in 2013″. The Bank of England has around £375 billion gilts on its balance sheet; and the Bank of Japan is expected to buy about ¥15 trillion ($180 billion) of JGBs.
The second theme is regulation. I’ll let Singh explain:
Regulatory demands stemming from Basel III, Dodd Frank etc., are expected to silo $2-$4 trillion of collateral. Higher liquidity coverage ratio(s) (or LCRs) at banks, along with collateral needs for CCPs (and especially non-cleared OTC derivatives) are some of the key regulatory changes that will impact collateral markets. Recent proposals include provisions for sub AAA/AA assets to qualify for LCR. Similarly, eligible collateral at some CCPs already includes commodities (e.g., gold), corporate bonds (CME), equities, MBS (e.g., LCH Swapclear), renminbi (CME) etc. Some CCPs (especially at the request of buy side) are now seeking alternatives to title transfer that will allow clients to pledge securities as margin collateral. These safety buffers will silo the associated collateral and drain collateral from the financial markets. However, the regulatory proposals are staggered with changes that will be phased-in over the next five years.
Next up is what Singh rather boringly refers to as ”collateral custodians/depositories’, but it is very important. You might even spot a favorite or two:
In summer 2011, Eurozone had about €14 trillion in eligible collateral but much of it is either (i) locked in “depositories” and thus not easily accessible for cross border use; or, (ii) the asymmetry of demand for collateral in the ‘peripheral’ countries relative to the ‘core’ countries was at odds with the sizable availability of eligible collateral. Recently however, Euroclear and Clearstream (the key hubs for Eurozone collateral) are working with the local CSDs (or national/central security depositories) to alleviate collateral constraints. The interconnections to the CSDs will be via the Target 2 Securities (T2S) system that will provide a single pan European platform for securities settlement in central bank money.
Preliminary estimates suggest that perhaps up to €1- €1.5 trillion of AAA/AA quality collateral may be unlocked in the medium term via efforts of custodians to optimize collateral and build a collateral highway or global liquidity hub. However, the internal “plumbing” (i.e., operations, workflows, technology, staff etc) that is required to process and manage trillions of collateral balances needs to be smooth.16 Even if this collateral does not reach “large banks/markets”, it allows the collateral to leave “CSD silos”, improve efficiency, and enhance accounting debt and credits and reduce the burden on markets to provide collateral for LCR or CCP related regulatory buffers.
Okay, so not all bad, although ‘solved’ might be an over statement, as evident in footnote 16:
16. Every institution or market is different; there is a lot of friction in the pipes. Even though legally collateral is allowed to be re-used but if a counterparty along the collateral chain hasn’t built the system to do anything with it, the collateral gets “stuck” in the plumbing. The frictions in aggregate can be quite sizeable and may be another reason why the theoretical balances may not add up mathematically.
Finally, we have new net issuance of debt:
Assuming AAA/AA countries have GDP of around $25 trillion and with a deficit of around 4-5 percent, they have supplied (on average) about $1 trillion of new (net) debt—sovereign and corporate–every year, with latest data on the lower side. 20 Database and market contacts suggest that on average about 30%-40% of AAA/AA collateral inventory reaches markets via custodians for re-use (on behalf of reserve managers, SWF, pension, insurers etc); however, much of the inventory stays with buy and hold investors. So if Debt/GDP remains on trend in developed countries (i.e., the ratio does not increase sizeably), new debt stemming from the “numerator” may provide up to $300-$400 billion per year to the markets assuming counterparty risk especially with European banks does not elevate. Another 5%-10% of new inventory (including equities) may come via hedge funds. With a collateral reuse rate of about 2.5 (and assuming this does not decrease due to the various silo(s) in the “new” collateral space) this may alleviate collateral shortage by about $800 billion to $1.2 trillion per year.
And here’s how it all looks graphically:
And so Singh suggest a couple of policies. Central banks could, for example, “rent” out their good collateral (and their balance sheet) as this will increase collateral velocity as the good/bad collateral ratio will rise.
In summary, the tone over the medium term is somewhat positive, but there is in my opinion a very big *if*:
Collateral scarcity is distinct from collateral shortage. 31 Annual collateral “flows” (e.g., via new net debt issuance) may seem less relative to desired collateral “stocks” (e.g., for regulatory buffers) but that may not be the case over a five year cycle. Several competing developments have been in motion in recent years with positive and negative implications for the collateral market s: ECB’s LTROs (+), Fed and SNB actions (-); new net debt issuance (+); collateral velocity (-). In the near future, sustaining collateral velocity (i.e., collateral re-use by markets) will be important since there is an unfortunate constellation—from central bank actions and regulatory proposals—that will silo good collateral. Fine-tuning some regulatory demands will alleviate collateral scarcity in the near term. So will actions from some central banks that have vested interest to provide good collateral in the markets. In the medium term, assuming no major dislocation in financial markets, central banks are likely to unwind sizable good collateral from their balance sheet and alleviate shortages (if any).