Faster than the speed of markets鈥� plight
04 March 2014
When should collateral change hands, and when should it stay put?
Image: Shutterstock
Late last year, International Monetary Fund senior economist Manmohan Singh commented that central banks cannot rely on institutions鈥� excess reserves of collateral to supply the market.
鈥淗edge funds are the single largest suppliers of collateral,鈥� he said, followed by large banks, which act as custodians of large supplies, and then entities such as pension funds and insurers. Hedge funds, he explained, had $1.8 trillion in pledged collateral at the end of 2012, up slightly from $1.7 trillion in 2007, while others, including US and European banks, had $1 trillion in 2012 compared to $3.4 trillion in 2007.
In 2007, those entities held a combined volume of $10 trillion, but this dropped to $6 trillion in 2012. The velocity of that collateral fell from 3 units to 2.2 units over the five-year period. 鈥淐ollateral moves鈥攊t finds the maximum price in the chain,鈥� said Singh, adding: 鈥淪iloing is not good for financial lubrication.鈥� Unfortunately, 鈥渃ollateral velocity鈥攐r re-use鈥攊s coming down.鈥�.
Central banks point to institutions鈥� excess reserves as useful sources, but 鈥済ood collateral in the market has velocity鈥� and cannot be left to stagnate on balance sheets, like it did after the Lehman Brothers crisis.
In his November 2011 working paper for the International Monetary Fund, Velocity of Pledged Collateral, Singh used Goldman Sachs鈥檚 2009 10k report as an example of a financial statement detailing collateral rehypothecation. It showed, he wrote in his paper, a similarity with financial statements of both US and European collateral dealers. As a result, he could use it as data on pledged collateral, because it was comparable across these institutions, at least to some extent.
Goldman Sachs鈥檚 2009 10k report showed that as of December 2009 and November 2008, 鈥渢he fair value of financial instruments received as collateral by the firm that it was permitted to deliver or re-pledge was $561 billion and $578 billion, respectively, of which the firm delivered or re-pledged $392 billion and $445 billion, respectively鈥�.
Looking at the firm鈥檚 most recent 10k report, as of December 2012, the firm had $540.95 billion in collateral available to be delivered or repledged, compared to $622.93 billion the year before. It delivered or repledged $397.652 billion in 2012, down from $454.604 billion in 2011.
There are myriad reasons why Goldman Sachs and others may have held back collateral, and broke the 鈥榗hain鈥�, as Singh describes it, but many are in agreement that regulations are having an effect, partly because they are not harmonised.
As attendees of the 20th Beneficial Owners鈥� International 网爆吃瓜 Lending Conference in January heard, regulations concerning systemic risk are trying to provide transparency to regulators, and encompass collateral re-use, hypothecation, pro-cyclicality, and risks arising from fire sale of collateral assets.
But regulations concerning investor protection have a different aim.
They are attempting to address the disclosure of counterparty risk and potential conflicts of interest, disclosure of fees, disclosure of lending agents, and clear and consistent disclosure of net lending revenue.
In a securities lending context, an example of systemic risk would be the Financial Stability Board鈥檚 (FSB) shadow banking proposals, specifically, the recommendation on imposing minimum haircuts.
By contrast, the FSB also has recommendations that would see fund managers increasing disclosure to their investors, which relates to investor protection.
The FSB鈥檚 minimum haircut proposal may also be misguided, argued the International Capital Market Association鈥檚 European Repo Council and the International 网爆吃瓜 Lending Association in a recent letter to the FSB.
Their letter began by stating that they were unconvinced that haircut practices in the repo and securities lending markets contributed materially to the financial crisis.
Evidence gathered by bodies such as the Committee on the Global Financial System, they alleged, makes it clear that the withdrawal of funding from some weakened institutions largely took the form of the withdrawal of credit lines and certain types of collateral becoming ineligible.
A mandatory through-the-cycle haircut may therefore do little to prevent pro-cyclicality in another crisis, they said.
The associations stated that they believed that the focus of these rules should be firmly on the financing of non-prudentially regulated entities, by banks and regulated broker-dealers subject to prudential regulation and risk weighted capital charges.
鈥淭his approach has the advantage of focusing regulatory scrutiny on the regulated sector, making implementation and supervision more straightforward, but we believe that care is needed to ensure that the rules do not drive financing activity away from regulated firms,鈥� the letter went on to say.
鈥淲hilst the numerical floor proposals are restricted in scope in this way, the recommendation for minimum standards for methodologies applies to all market participants and this may have some serious unintended consequences.鈥�
Discouraging business, or breaking the collateral 鈥榗hain鈥�, goes against the grain of what regulators are trying to achieve, many agree. Luckily, technology is in place to allow easy re-use and rehypothecation, if institutions want to conduct that business.
Christian Rossler, head of global securities financing, sales and relationship management APAC at Clearstream, says re-use or rehypothecation of collateral has been possible on a transfer of title basis via Clearstream鈥檚 Liquidity Hub since 2006. For the latter, the legal title has to be passed from the giver to the receiver, and the receiver can re-use it. If there is a lean on the collateral, the receiver cannot re-use it, so it has to be free of any legal pledge.
鈥淲e have also provided for it in collateral management service agreements, so those are water tight in that sense.鈥�
鈥淎nd technically, we have managed to offer re-use to our customers because of what we call 鈥榗entral accounts鈥�, which is simply a pivot account where if you get assets and you want to re-use them, they are channeled over the central account and then they can be re-used again.鈥�
Rossler says that Clearstream does not dictate to its customers how to re-use collateral. It is simply an option, he explains.
鈥淲ith a basket of collateral, they can decide to only re-use a single piece of that basket. We don鈥檛 tell them how much they have to re-use, and there is an unlimited number re-uses allowed in our system.鈥�
鈥淭his is possible because we provide all along the re-use chain the information back to the original collateral giver, because as long as the collateral stays in our collateral exchange system, C-Max, we can offer an unlimited number of re-uses.鈥�
鈥淗edge funds are the single largest suppliers of collateral,鈥� he said, followed by large banks, which act as custodians of large supplies, and then entities such as pension funds and insurers. Hedge funds, he explained, had $1.8 trillion in pledged collateral at the end of 2012, up slightly from $1.7 trillion in 2007, while others, including US and European banks, had $1 trillion in 2012 compared to $3.4 trillion in 2007.
In 2007, those entities held a combined volume of $10 trillion, but this dropped to $6 trillion in 2012. The velocity of that collateral fell from 3 units to 2.2 units over the five-year period. 鈥淐ollateral moves鈥攊t finds the maximum price in the chain,鈥� said Singh, adding: 鈥淪iloing is not good for financial lubrication.鈥� Unfortunately, 鈥渃ollateral velocity鈥攐r re-use鈥攊s coming down.鈥�.
Central banks point to institutions鈥� excess reserves as useful sources, but 鈥済ood collateral in the market has velocity鈥� and cannot be left to stagnate on balance sheets, like it did after the Lehman Brothers crisis.
In his November 2011 working paper for the International Monetary Fund, Velocity of Pledged Collateral, Singh used Goldman Sachs鈥檚 2009 10k report as an example of a financial statement detailing collateral rehypothecation. It showed, he wrote in his paper, a similarity with financial statements of both US and European collateral dealers. As a result, he could use it as data on pledged collateral, because it was comparable across these institutions, at least to some extent.
Goldman Sachs鈥檚 2009 10k report showed that as of December 2009 and November 2008, 鈥渢he fair value of financial instruments received as collateral by the firm that it was permitted to deliver or re-pledge was $561 billion and $578 billion, respectively, of which the firm delivered or re-pledged $392 billion and $445 billion, respectively鈥�.
Looking at the firm鈥檚 most recent 10k report, as of December 2012, the firm had $540.95 billion in collateral available to be delivered or repledged, compared to $622.93 billion the year before. It delivered or repledged $397.652 billion in 2012, down from $454.604 billion in 2011.
There are myriad reasons why Goldman Sachs and others may have held back collateral, and broke the 鈥榗hain鈥�, as Singh describes it, but many are in agreement that regulations are having an effect, partly because they are not harmonised.
As attendees of the 20th Beneficial Owners鈥� International 网爆吃瓜 Lending Conference in January heard, regulations concerning systemic risk are trying to provide transparency to regulators, and encompass collateral re-use, hypothecation, pro-cyclicality, and risks arising from fire sale of collateral assets.
But regulations concerning investor protection have a different aim.
They are attempting to address the disclosure of counterparty risk and potential conflicts of interest, disclosure of fees, disclosure of lending agents, and clear and consistent disclosure of net lending revenue.
In a securities lending context, an example of systemic risk would be the Financial Stability Board鈥檚 (FSB) shadow banking proposals, specifically, the recommendation on imposing minimum haircuts.
By contrast, the FSB also has recommendations that would see fund managers increasing disclosure to their investors, which relates to investor protection.
The FSB鈥檚 minimum haircut proposal may also be misguided, argued the International Capital Market Association鈥檚 European Repo Council and the International 网爆吃瓜 Lending Association in a recent letter to the FSB.
Their letter began by stating that they were unconvinced that haircut practices in the repo and securities lending markets contributed materially to the financial crisis.
Evidence gathered by bodies such as the Committee on the Global Financial System, they alleged, makes it clear that the withdrawal of funding from some weakened institutions largely took the form of the withdrawal of credit lines and certain types of collateral becoming ineligible.
A mandatory through-the-cycle haircut may therefore do little to prevent pro-cyclicality in another crisis, they said.
The associations stated that they believed that the focus of these rules should be firmly on the financing of non-prudentially regulated entities, by banks and regulated broker-dealers subject to prudential regulation and risk weighted capital charges.
鈥淭his approach has the advantage of focusing regulatory scrutiny on the regulated sector, making implementation and supervision more straightforward, but we believe that care is needed to ensure that the rules do not drive financing activity away from regulated firms,鈥� the letter went on to say.
鈥淲hilst the numerical floor proposals are restricted in scope in this way, the recommendation for minimum standards for methodologies applies to all market participants and this may have some serious unintended consequences.鈥�
Discouraging business, or breaking the collateral 鈥榗hain鈥�, goes against the grain of what regulators are trying to achieve, many agree. Luckily, technology is in place to allow easy re-use and rehypothecation, if institutions want to conduct that business.
Christian Rossler, head of global securities financing, sales and relationship management APAC at Clearstream, says re-use or rehypothecation of collateral has been possible on a transfer of title basis via Clearstream鈥檚 Liquidity Hub since 2006. For the latter, the legal title has to be passed from the giver to the receiver, and the receiver can re-use it. If there is a lean on the collateral, the receiver cannot re-use it, so it has to be free of any legal pledge.
鈥淲e have also provided for it in collateral management service agreements, so those are water tight in that sense.鈥�
鈥淎nd technically, we have managed to offer re-use to our customers because of what we call 鈥榗entral accounts鈥�, which is simply a pivot account where if you get assets and you want to re-use them, they are channeled over the central account and then they can be re-used again.鈥�
Rossler says that Clearstream does not dictate to its customers how to re-use collateral. It is simply an option, he explains.
鈥淲ith a basket of collateral, they can decide to only re-use a single piece of that basket. We don鈥檛 tell them how much they have to re-use, and there is an unlimited number re-uses allowed in our system.鈥�
鈥淭his is possible because we provide all along the re-use chain the information back to the original collateral giver, because as long as the collateral stays in our collateral exchange system, C-Max, we can offer an unlimited number of re-uses.鈥�
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