Streetwise Professor

February 5, 2013

Collateral Crunches. Who Knew? Did You Even Need to Ask?

Hint: collateral crunches are not an ab exercise.  Instead, regulators and legislators around the world are waking up to the reality of what they have wrought: that the regulations that they blithely decided to impose on the derivatives markets are likely to have severe adverse consequences.  Specifically, Europeans have awakened to the fact that clearing and collateral mandates will be extremely burdensome on firms that use derivatives to manage risk, but who pose no real systemic threat.  Thus, a committee of the European Parliament has voted to send clearing regulations back to the European Commission for reconsideration.  There is a realization that a “collateral crunch” is impending as a result of these various regulations:

This has led to talk of a “collateral crunch”, with most central counterparties accepting only government bonds or cash as collateral, assets that may not be readily available. This is more restrictive than at present, with corporate bonds and even equities often accepted as collateral in uncleared bilateral deals, if lodged in sufficient quantity.

The problem may be particularly acute for mutual funds, as an equity or corporate bond fund will simply not possess anything it can use as collateral. Instead it may have to use the securities lending or repo markets to secure suitable assets.

But many pension funds will also be hit. As Mr Haines points out, even the index-linked government bonds that pension funds do tend to hold in abundance are not generally accepted as collateral by central counterparties, even if conventional bonds issued by the same governments are.

Estimates of the cost of using the repo market to access the necessary collateral range from 50 basis points of a pension fund’s assets to several hundred basis points, Mr Haines adds. Alternatively, pension funds may feel pressured to alter their asset allocation so they do have sufficient in-house collateral.

Totally unpredictable, right?  Uhm, not really.

I find it particularly amusing that virtually every article on the effects of Frankendodd and Emir bewail the “unintended consequences.”  A million pardons, but that was a theme here on SWP, and in various presentations I made, before Frankendodd and Emir were actually adopted.  Unintended, but eminently foreseeable-and totally ignored.

The recent angst focuses on initial margin: the amount of capital that has to be tied up to support derivatives positions from the moment they are initiated.  Given that collateral is costly, the large increases in initial margin will require derivatives users to choose between continuing to use them to manage risk, but obtain lower returns, or to eschew derivatives and live with greater risk.

The benefit received in exchange for this very real cost?  Given that many entities so affected pose no systemic risk, it’s quite difficult to identify any gain.

Not that initial margin is unimportant, but the focus on it distracts attention from what I believe to be the true systemic risk inherent in clearing and collateral mandates: the contingent needs for liquidity to make variation margin payments.  Big price moves lead to big variation margin flows.  These will tend to occur when markets are stressed and liquidity becomes scarce.  Thus, the need to make variation margin payments will exacerbate stresses on the market, especially will stress liquidity supply mechanisms.  Given that financial crises are, typically, liquidity crises, this is a major systemic problem.

So by all means pay attention to the drag that the dramatic increase in initial margin requirements will impose.  This is a drag that will be experienced day after weary day.  But do not overlook the truly dangerous unintended consequence of the clearing and collateral mandates in Frankendodd and Emir.  The stress that these mandates will put on liquidity supply mechanisms at the precise instant that these mechanisms are at risk of failure.

What could go wrong?

I say again: regulate/legislate in haste, repent at leisure. The seeds for the next crisis are being sown in the alleged attempts to prevent a recurrence of the last one.  Legislative and regulatory generals fighting the last war.

Print Friendly


  1. [...] February 6th, 2013 Collateral Crunches. Michael Dell (Photo credit: veni [...]

    Pingback by Breakfast Links - Points and Figures | Points and Figures — February 6, 2013 @ 4:51 am

  2. Blackrock has a very good analysis of the evolution of liquidity in post-crisis markets: . The importance of the overnight repo market and rehypothecation of customers’ assets plays into this whole thing in a big way.

    My own view: Another liquidity event in the overnight funding markets could, once again, become a solvency event for many of the firms relying on this as a source of funding. If repo liquidity evaporates again it will immediately radiate thru the entire system. I think many market participants still worry about this, as the Blackrock analysis makes clear. And, they’re hoarding high-quality collateral and limiting their repo exposure. Essentially, they’re buying and holding new-issue high-quality fixed-income stuff and starving the trading markets.

    Real liquidity — the ability to move size on a tight bid-ask and warehouse whatever you can’t immediately trade out of at a reasonable cost — is still limited. What’s available is becoming concentrated in vanilla exchange-tradeable products. The supply of suitable, re-hypothecatable collateral (what an expression!) is shrinking. This feeds into the loop causing liquidity to contract, which is widening bid-ask spreads, which itself induces volatility in the evolution of prices. (See )

    This doesn’t even touch on the dark pools, which presumably operate as SROs. These pools take trading liquidity away from the general market and concentrate it in dense trading networks, access to which is controlled by the pool operator-gatekeeper. If I had to bet, I’d bet this is where you’re going to see a major liquidity event transform into a solvency event that quickly radiates into the wider markets.

    Comment by markets.aurelius — February 6, 2013 @ 5:05 am

  3. Amen, Markets. I am not sure if the dark pools will cause the liquidity crunch in and of themselves – the issue is that they seem to be shrinking of late, but a lot of stuff that was never traded, such as CLO AAA bonds, are showing up on regular Seller/buyer screens. Not a lot to date, but it is starting. Does disintermediation sound like the correct term? Not a rhetorical question.

    This brings the warehousing aspect of liquidity to the fore – there doesn’t seem to be enough (or the appetite for a true intermediary, that is one that doesn’t have to run a flat and empty book net of settlement at EOD.

    Another thing to consider is that the pool of collateral has always been inadequate relative to the size of the market. While this seems amazing given the amount of Debt the ONE has created, let’s remember the Fed has monetized a lot of it, and other post-able collateral, such as Agency MBS, have been gobbled up as the repo market for both has picked up.

    Finally, if you really want to look at the trend or appetite for the market for using nontraditional collateral, look at the trend over the last five years in ABCP – Niagara has nothing on it.

    Comment by Sotos — February 6, 2013 @ 2:52 pm

RSS feed for comments on this post. TrackBack URI

Leave a comment

Powered by WordPress