Collateral, contagion and CCPs

In adding in this way to the complexity of the task of understanding the true state of monetary conditions, central banks have only themselves to blame. They have never lent money to anyone without collateral, and they have made plain for years their belief that commercial banks should follow their example. Even now, they are encouraging the shift of transactional activity in derivatives as well as cash market instruments to central counterparty clearing houses (CCPs), whose principal means of risk management is collateralization through the taking of initial and variation margin. Naturally, this is increasing the demand for high quality collateral. Yet the central banks are at the same time preparing a regulatory attack on the so-called “shadow banking” system which used and re-used collateral to enable one group of non-banks (money market funds) to fund another (broker-dealers) so that they could in turn fund a third (hedge funds). They are doing this by increasing the capital and liquidity ratios faced by banks, and by forcing money market funds to behave more like banks. So central banks are pursuing a curiously contradictory set of policies. After all, it was the collapse of the shadow banking system that precipitated the crisis in 2007-08, and it is its failure to revive that has forced the central banks to replace the liquidity it once provided through the “printing” of money to purchase securities.

There is a view, particularly in the hedge fund and prime brokerage industries, that financial markets cannot return to normality until the task of reflating the financial economy is reassumed by the shadow banking system. As a recent paper on Shadow banking and repo published by the International Capital Markets Association (ICMA) puts it, “shadow banking is an alternative (and pejorative) term for market finance.” Central banks, however, are currently more concerned about the role played by “market finance” – namely, the repo markets - in precipitating and accentuating the financial crisis, especially in its acute phase between 2007 and 2009. On this view, the price of collateral rose steeply in 2007-09, reducing the liquidity of market participants, and sparking a collapse of asset prices as they sold securities to raise cash. Tougher liquidity ratios are the first of a series of measures designed to address that source of systemic risk, and specified but stable haircuts for particular types of collateral are now being discussed as another part of the solution. The collateral haircuts set by central banks are already becoming industry-standard benchmarks in the repo markets.

Judged as part of an overall policy designed to shrink the size and reduce the amplitude of the shadow banking credit cycle, the central bank policy of printing money and raising the price of collateralised credit seem less contradictory. Whether by accident or design, the purchase of government securities by the central banks as part of the quantitative easing programmes now in train in the United States and Europe has removed high quality as well as low quality sovereign collateral from circulation. The recycling of the money printed by the central banks into cash deposits at the central banks has removed cash and cash as collateral from the markets too. In tandem with the increased demand from CCPs and their users, this has even created the prospect of a collateral shortage. This is a particularly ironic outcome at a time when the fiscal incontinence of governments in Europe and North America is injecting vast quantities of central bank-eligible collateral into the marketplace. In fact, the loosening of collateral eligibility criteria by the central banks is a reminder that the crisis has made access to sovereign collateral (Greece, Italy, Portugal and Spain apart) more important than ever, by narrowing the range of collateral acceptable in return for commercial bank money, as opposed to its central bank equivalent.

But a factor of even greater importance to a looming collateral shortage may also be happening, less visibly. Manmohan Singh of the IMF has pointed out that the crisis has not only reduced the amount of collateral available but also reduced its velocity of circulation, by shrinking the number of times any one piece of collateral is re-used. Singh has estimated that the pool of collateral available for use by the repo desks of the major investment banks in 2007 was worth $10 trillion, of which just $3.3 trillion represented original (as opposed to re-used) securities. He estimates that by the end of 2010 this collateral pool had shrunk to $5.8 trillion, of which $2.45 trillion represented original securities. In other words, the velocity of circulation of collateral fell from 3 times in 2007 to 2.4 times in 2010. The result is a reduction in the amount of credit available to borrowers who can pledge collateral. This `de-leveraging’ of the financial system since the crisis began in 2007 is a well-attested phenomenon, and the fall in the velocity of collateral goes some way towards explaining why it has happened. It also explains why the balance sheets of the Federal Reserve and the Bank of England have had to increase four-fold since August 2007 to make up the shortfall.

The chief agents in the process of collateral re-use – or, as they call it, re-hypothecation – are the investment banks, chiefly through their prime brokerage businesses. Re-hypothecation is at the heart of how the prime brokerage business works. Effectively, hedge funds place all of their cash and securities in custody with their prime broker in return for financing. The prime broker raises that finance by re-pledging those same assets in the repo and reverse repo markets. Custodian banks add to the pool of collateral available for re-hypothecation by lending to the investment banks the assets of their institutional custody clients. In the United States, the process of re-hypothecation was and is limited by Reg T to 50 per cent of the value of the fully paid-for securities, meaning the assets can be leveraged two-fold only. In the United Kingdom, by contrast, there is no restriction – which is why so many investment banks funnelled their financing activities through their London operations in the years before the crisis. As many hedge funds that used Lehman Brothers International found out to their dismay, assets could be re-used multiple times, creating a pyramid of credit balanced on a narrow base of original collateral.

Today, the prudent hedge fund insists on no re-hypothecation at all, or limits it to the value of any sums borrowed or some agreed percentage of the assets in custody with the prime broker, and places unencumbered assets with a third party custodian – even though this can increase the cost of financing as much as five-fold. This has further reduced the amount of collateral available to the investment banks to recycle. The regulatory enthusiasm for greater use of CCPs is simultaneously increasing the demand for eligible collateral, and not only because each CCP devours initial and variation margin of its own. With the number of CCPs multiplying, the need for them to inter-operate - though the scope for this will inevitably be limited to single legal jurisdictions - implies that they will have to collateralise each other as well.

This raises an interesting question, which only experience can address. It is whether the CCPs will prove adequate substitutes for a shrunken shadow banking system. In a sense, they are ideally suited to the task of increasing the velocity of circulation of collateral, since they are founded on the concept of netting risks off against each other, and economising on the use of collateral as a result. Yet CCPs are less than appetising as counterparts, since they concentrate both counterparty and product risk (most are specialising in particular asset classes), compete for business on margin methodologies if not collateral types, and are not explicitly backed by the central banks if they fail. It would take a heart of stone not to laugh if, having largely eliminated the shadow banking system, the central banks found themselves in a few years’ time riding to the rescue of a series of interconnected CCPs trapped in a downward, self-reinforcing collateral-asset valuation spiral.

Tags: CCPCollateralICMA