Collateralising the collateral

It is a clear goal in the post-2008 financial landscape to push towards risk mitigation and transparency. Mandates such as clearing and reporting are being phased in to ensure both pillars are built into financial markets, but how can they be guaranteed? Through the posting of collateral against trading activity.

Collateral management, once an unsung back office function, is now taking centre stage. With OTC derivatives transactions being forced through clearing houses (CCPs), each trade needs to be collateralised to provide some insurance in the event of a default. The clearing obligation is extending beyond just OTC transactions, however, and is headed for repo transactions as well. For clearing houses to effectively mitigate risk in the markets and act as a buyer to every seller and a seller to every buyer, then they need to have highly liquid collateral posted as margin against the trades that they are guaranteeing.

Quantative Easing (QE) is the process of central banks purchasing government bonds and is witnessing the stockpiling of these highly liquid securities at the central banks. This is occurring at a time when there is very little new government debt in issuance (as we looked at previously, here: Collateral for clearing - a race to the bottom?)

The European Central Bank (ECB) commenced its QE programme on 9 March 2015. It launched a €1.1 trillion operation with a plan to purchase around €60 billion of debt every month until September 2016. This policy has already hit a large potential snag, however, in the distinct possibility that yields on 10-year German bunds could fall below 0 per cent. This is a result of a surfeit of cash in the market as a result of QE; central banks are pumping cash into the market by purchasing government debt, which is driving down interest rates.

In a bid to assuage fears of insufficient collateral, in the form of these liquid government bonds, being available to market participants, the ECB announced on 2 April 2015 a programme to lend out the stockpiled securities with the intention, “to support bond and repo market liquidity without unduly curtailing normal repo market activity.” You can read the full ECB programme here: https://www.ecb.europa.eu/mopo/implement/omo/pspp/html/pspp-lending-ecb.en.html

One problem with the ECB’s programme is that its lending rates are higher than general market rates for borrowing securities. It has a fixed rate of 40 basis points, the difference between repo and reverse repo rates. The lending is conducted with a fixed maturity of one week with the possibility to roll over the transaction week-by-week for up to three weeks, with a fee increase of 10 basis points each time. As well as this, eligible counterparties (the ECB will not lend to just anyone) must post collateral against the transaction; “The acceptable collateral consists of the full range of PSPP(the ECB’s QE programme)-eligible securities.”

So, to get their hands on collateral, counterparties must post collateral to do so. In effect, they are collateralising the collateral.

Outside of Europe, the central clearing of repo transactions is inching closer in the US, with the Federal Reserve pushing for a decrease in the risk exposure to larger firms defaulting, such as the turn of events following the collapse of Lehman Brothers in 2008, via central clearing. Financial firms move closer to central clearing in repo market

Central clearing is in vogue amongst regulators the world over following the 2009 G20 summit in Pittsburgh, where it was, in effect, put forward as something of a silver bullet to future financial market woes. In order for the CCPs to hold up in the face of this task, however, participants in them must sufficiently collateralise their positions – if they default, the CCP can then liquidate that participant’s collateral to make good on their outstanding positions.

Most market participants do not hold stockpiles of government debt, so they have to use the repo market to get it from those that do; pension funds, for example, and others with low risk, long-only investment strategies. The repo markets are coming under the regulatory gaze as they make up a section of the Shadow Banking industry, as we have looked at previously: Shadow banking and the regulatory capital question

Repo transactions conducted through CCPs will, of course, need collateralising with suitable collateral. Again, we will witness the collateralising of the collateral.

With government debt being purchased in huge volumes by central banks under QE programmes, at a time when government bond issuance is approaching 0 per cent per annum, the cost of derivatives and repo transactions is going to rise. If sufficiently liquid collateral just is not available to market participants, then one of the only ways that trading in these markets can continue is if the CCPs, the gatekeepers of them, lower their eligibility criteria as regards suitable collateral to be posted against positions. This will increase risk since illiquid collateral at a CCP at a time of participant default and market stress will result in the CCP being unable to function as the buyer to every seller and the seller to every buyer, resulting in another financial crisis. 

Tags: RegulationCCPsCollateralLiquidityQEECBShadow Bankingrepo marketsOTC