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.