The relative price(s) of money and collateral matter for financial lubrication in the markets. Some central banks are now a major player in the collateral markets. Analogous to a coiled spring, the larger the quantitative easing efforts, the longer the central banks will impact the collateral market and associated repo rate. This may have monetary policy and financial-stability implications since the repo rates maps the financial landscape that straddles the bank/non-bank nexus.
Introduction
The importance of collateral has been investigated in several strands in the theoretical literature. One strand is the literature on collateral and default, which has focused primarily on the role of margin and “haircuts” and “fire sales” (Geanakoplos 2003;
Krishnamurthy, Nagel, and Orlov 2010). Another strand is on securitization, where collateral serves to support specific asset values (Shleifer and Vishny 2011).
This chapter echoes discussions on the supply and demand of safe assets. Empirical evidence that the (demand for) safe-asset share has been relatively stable was postulated by Gorton et al. (2012) using flow-of-funds data only. Concerns have been raised about the supply of safe assets. The IMF’s Global Financial Stability Report estimated a US$74 trillion figure for safe assets (April 2012), which would appear to be ample. However, a large fraction of such safe assets is held by buy-and-hold investors and is not available for reuse in financial markets. Some market sources conclude that there is little evidence to support that good collateral will be in short supply (J. P. Morgan). Others argue that there could be such a shortage and that safe assets should be provided as a public good to avoid financial instability associated with the private supply of safe assets.
This thinking is now being reflected in the US Federal Reserve’s recent reverse repo program.
This contribution has three aims. It first clarifies the distinction between the price of money and the price of collateral. It then discusses the factors driving the demand and supply of collateral. Finally, it highlights the importance of collateral for monetary policy through an updated IS/LM framework. With this, the contribution reflects on the prospects for unwinding extraordinary monetary policy interventions.
Price of Money and Price of Collateral
The price of money and the price of collateral are set through distinctive practices during
“normal” times. Central banks use open-market operations—that, when conducted through repos, involve collateral—to target a money market interest rate that is consistent with their desired path for consumer prices. Now consider collateral or repo rates. Recall that collateral rate (or repo rate) is the rate at which cash is lent against collateral for an agreed tenor. It is agreed upon by the two parties at t0 or start of repo. Typically, collateral shortage lowers repo rates; collateral abundance increases repo rates. This rate is a proxy for collateralized transactions that underpin the financial plumbing between the dealer banks/non-banks.
Unconventional monetary policies may sharpen the distinction between the price of money and the price of collateral during crisis. In some countries like the USA and the UK, the price of money and money market rates are not market-determined if central banks decide to pay interest on excess reserves (IOER) to depository institutions.
Following the Lehman failure, the Fed introduced interest on excess reserves for depository institutions. This was intended to place a “floor” (minimum bid) on short-term liquidity in the corridor system. This creates a wedge between banks and non-banks, and thus impacts other short-end rates. For example, in the USA, Freddie, Fannie and other non-depository institutions are not eligible to deposit excess reserves at the Fed and thus do not have access to IOER. However, Fannie and Freddie cannot access IOER (25 basis points) that banks can only receive, and, therefore, GSE cash positions (and cash positions of other home loan banks) have largely determined the federal funds rate, which trades below the IOER “floor.” This wedge between IOER and the federal fund rate is important; the rate on July 29, 2013 was 9 bps, quite far from the likely first step in tightening rates.
The IOER in the USA has also been instrumental in keeping a wedge between comparable repo rates in the USA and those in the Eurozone (see Figure 9.2). Recently
Figure 9.1. Collateral rates in selected Eurozone countries (left) and the USA (right)
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Fed Funds Rate IOER Treasury GCF Repo ECB Deposit Rate France Germany
Sources: ICAP, Bloomberg, DTCC, and staff estimates.
in the Eurozone, collateral/repo rates have dipped below zero; these include German/
French/Dutch and also Danish/Swiss repo rates.1 However, this is not the case with collateral/repo rates in the USA. In theory, the price of “good collateral” should not vary across assets except due to technical factors, including “home” bias, the liquidity/depth/
size of good European collateral relative to the US T-bill market, different types of QEs (Fed vs ECB), the cheapest to deliver collateral, etc. Operation Twist also provided an extra dose of T-bills in 2012 to provide some lift to the GC rates. Thus good collateral like US GC rates are still in positive territory relative to good collateral in the Eurozone that has been in negative territory. In the USA, it remains to be seen if cash shifts from repo to bank deposits when overnight GC goes negative in. There’s a big psychological barrier between explicitly paying for protection and “accepting a lower return” to get protection.
The Changing Collateral Space
A great deal of short-term financing is generally extended by private agents against financial collateral. In the “old” global financial system, non-banks were the primary actors that allowed reuse of their collateral in lieu of other considerations. Earlier work has highlighted that the key providers of pledged collateral to the “street” (or large banks/dealers) are hedge funds and custodians on behalf of pensions, insurers, and official sector accounts, etc. (Figure 9.2).2 In this nexus of non-banks/banks,
“supply” of pledged collateral is typically received by the central collateral desk of the large banks/dealers that reuse the collateral to meet the “demand” from the financial system.
When mapping the changing collateral space in Figure 9.2, we assume that the debt/GDP of developed countries will not increase significantly (otherwise the topic of collateral shortage is moot). Also we assume that regulation and collateral standards will not become so lax that junk will be deemed as “good collateral” with only a token haircut. We also acknowledge a new supply source—the recent reverse repo by the Fed that has started to provide collateral to banks and non-banks. We focus on collateral
“flows,” since whatever the stock of good collateral, only a fraction flows to markets to seek economic rent.
The rectangle in the center of Figure 9.2 depicts the volume in the old collateral space (in the orange area) and illustrates the reduction in collateral volumes as of end-2012, relative to end-2007. The recent crisis has resulted in elevated counterparty risk leading to incomplete markets and idle, and thus stranded, collateral pools. Also, some central bank purchases of good collateral have contributed to shrinkage in the pledged collateral market from US$10 trillion prior to the Lehman crisis (end-2007) to about US$6 trillion (end-2012).
Pledged collateral market (in the old collateral space) is different from some
“restricted” collateral markets. For example, securitization-based structures (SIVs) that have lien against specific pieces of collateral are impossible to re-pledge. Also the tri-party repo (TPR) market is a primary source of funding for banks in the USA, standing at US$1.7 trillion (end-2012). It provides banks with cash on a secured basis, with the collateral
being posted to lenders—like money-market funds—through one of two clearing banks:
BNY Mellon and J. P. Morgan. However, such pledged collateral sits with custodians and is not rehypothecable to the street. We ignored such restricted markets in the old collateral space, since collateral was not reusable, nor did it have restricted velocity.
The “new” collateral space straddles not only the bank/non-bank nexus (where collateral generates a velocity), but other participants who are now significantly impacting collateral availability. The increasing role of central banks, regulations, and collateral custodians is significantly changing the collateral landscape. These new dimensions involve (i) some aspects of unconventional monetary policies pursued by advanced-economy central banks that remove good collateral from markets to their balance sheet, where it is siloed; (ii) regulatory demands stemming from Basel III, Dodd–Frank, the EMIR, etc. that will entail building collateral buffers at banks, CCPs, etc.; (iii) collateral custodians who are striving to connect with the central security depositories (CSDs) to release collateral from silos; and (iv) net debt issuance from AAA/AA rated issuers.
Central banks (Figure 9.2, area on left)
Despite the ECB’s efforts to keep the ratio of good/bad collateral high in the EU financial markets, the actions of the SNB (and other central banks) are at odds with this objective.
Since the Swiss franc/euro peg in September 2011, the SNB balance sheet has grown sizably to about US$500 billion. About half of assets now comprise short-tenor “core”
Figure 9.2. The changing collateral space
OTC Derivatives Regulators
European Central Bank OLD COLLATERAL SPACE HAS VELOCITY (2.5 TO 3.0) Commercial banks
(–) / (+) refers to the impact on both the amount and velocity of collateral (–) negative for global liquidity
estimated USD 2–4 trillion additional collatreal needed e. g. liquidity ratios e. g. CCPs e. g. non-cleared
OTC derivatives
euro bonds and equities. This reflects prudent asset-liability management at the SNB.3 However, the SNB’s bond purchases withdraw the best and most liquid collateral from the Eurozone; this reduces the collateral reuse rate, since these bonds are siloed at the SNB, and are not pledged in the financial markets. Siloed collateral has zero velocity by definition. The ECB has expanded collateral eligibility, which includes lowering the asset-based securities’ threshold, and relaxing the foreign-exchange collateral requirement (i.e. non-euro collateral is eligible).
The Federal Reserve in the USA continues QE3 until labor markets turn around.
Since the Lehman crisis and since continuing with the QE efforts, the Fed is housing about US$2.8 trillion of “good collateral” (largely US Treasuries and MBS). Under Operation Twist (which ended last year), the Fed used to take in long-tenor debt of about US$45 billion per month and release short-term treasuries. That program kept the total size of the balance sheet unchanged. Then QE3 expanded the Fed’s holdings by another US$45 billion per month of long-term US Treasuries (without a parallel sale of short-term debt). Thus, along with QE3 buying of US$40 billion MBS per month, the Fed’s balance sheet is expanding by US$85 billion per month. At this rate, the Fed could silo over US$1 trillion additional good collateral in 2013 (and beyond, if there is no tapering). This is likely to have first-order implications for collateral velocity and global demand/supply of collateral. However, the Fed’s very recent reverse repo could be a game changer on the collateral front.
Other central banks, such as the Bank of England’s (BoE) QE efforts, have taken about £375 billion gilts onto its balance sheet; however, looking forward, the BoE is attempting to keep good collateral in the market domain with no more envisaged QE.
Also, the Bank of Japan is expected to buy about ¥15 trillion (US$180 billion) of JGBs, between its Asset Purchase Programme and rinban operations; however, JGBs have very low velocity since they are not used in “upgrade” trades, and are generally held by domestic investors.
New regulations: (Figure 9.2, area on the top)
Regulatory demands stemming from Basel III and Dodd–Frank are expected to demand US$2–4 trillion of collateral. Higher liquidity ratio(s) at banks, along with collateral needs for CCPs (and non-cleared OTC derivatives) are some of the other key regulatory changes that will impact collateral markets. These safety buffers will silo the associated collateral and significantly drain collateral in the financial markets (see Figure 9.4, top, yellow area).
Custodians (Figure 9.2, area on the right side)
The ECB mentions that the Eurozone has €14 trillion in collateral, much of it locked in “depositories” and thus not easily accessible for cross-border use (Figure 9.4, right side, pink area). However, Euroclear and Clearstream (the key hubs for Eurozone collateral) are working with the local/national CSDs to alleviate collateral constraints.
The interconnections to the CSDs will be via the Target 2 Securities (T2S) system
that will provide a single pan-European platform for securities settlement in central bank money. In the USA, J. P. Morgan and the Bank of New York may also improve collateral flows from within the US tri-party system; however, reforms on the tri-party system and money market funds will play a role in this effort. Preliminary estimates suggest that perhaps US$1–1.5 trillion of collateral may be “unlocked” via efforts of custodians to optimize collateral and build a “collateral highway.” This collateral in unlikely to reach markets, but will enhance accounting debt and credits to “break”
the silo.
Preliminary estimates suggest that perhaps up to €1–1.5 trillion of AAA/AA quality collateral may be unlocked in the medium term via efforts of custodians to optimize collateral and build a collateral highway or global liquidity hub. However, the internal
“plumbing” (i.e. operations, workflows, technology, staff, etc.) that is required to process and manage trillions of collateral balances needs to be smooth.
Every institution or market is different; there is a lot of friction in the pipes. Even though collateral is allowed to be reused legally, if a counterparty along the collateral chain has not built the system to do anything with it, the collateral gets “stuck” in the plumbing. The frictions in aggregate can be quite sizeable and may be another reason why the theoretical balances may not add up mathematically.
Even if this collateral does not reach “large banks/markets,” it allows the collateral to leave “CSD silos,” improve efficiency, and enhance accounting debt and credits, and reduce the burden on markets to provide collateral for LCR or CCP related regulatory buffers.The tri-party elements in Europe (i.e. Euroclear Bank and Clearstream Banking SA) also have about €900 billion of client collateral, but unlike in the USA, there is generally no intra-day credit to clients.
In the USA, J. P. Morgan and Bank of New York (BNY) may also improve collateral flows from within the US tri-party repo (TPR) system; however, regulatory reforms on the tri-party and money market funds may limit the size of the collateral market. Money market mutual funds (MMMFs) are an important money artery to the US financial plumbing system and support about one-third of the TPR market. If US regulations move this industry toward variable net asset value, then the money artery may shrink.
Lately, US MMMFs have had increasing difficulty finding balance sheets willing to provide investments. That implies that custodial banks such as State Street and BNY will likely grow because of their position as “balance sheet of last resort” for the MMMF industry (unless the Fed’s reverse repo leads MMMFs to shift en masse from the TPR to the Fed directly).
In general, central banks, SWFs, and long-term asset managers (life insurance and pension funds) desire collateral that has low volatility, but is not necessarily highly liquid.
These entities should be net providers of liquidity, either in the form of cash or liquid collateral. But critically, their “need” for collateral is relatively static (or, as providers of liquidity, they can dictate that counterparties take a fixed amount). On the other side the hedge funds, money market funds (and with the new regulations, the dealer banks too) have a dramatically shifting need for collateral and a large number of counterparties.
Their needs are for liquid collateral. So a market for collateral upgrades—in theory—
could work.
New (net) debt issuance: (Figure 9.2, area at the bottom)
Assuming AAA/AA countries have a GDP of around US$25 trillion and a deficit of around 4–5 percent, they have supplied (on average) about US$1 trillion of new (net) debt—sovereign and corporate—every year, with the latest data on the lower side.4 Database and market contacts suggest that on average about 30–40 percent of AAA/
AA collateral inventory reaches markets via custodians for reuse (on behalf of reserve managers, SWF, pensions, insurers, etc.); however, much of the inventory stays with buy-and-hold investors. So if debt/GDP remains on trend in developed countries (i.e. the ratio does not increase sizably), new debt stemming from the “numerator” may provide up to US$300–400 billion per year to the markets, assuming counterparty risk, especially with European banks, does not elevate. Another 5–10 percent of new inventory (including equities) may come via hedge funds. With a collateral reuse rate of about 2.5 in recent years (and now lower at 2.2 due to the various silo(s) in the “new” collateral space), this may alleviate collateral shortage by about US$800 billion to US$1.2 trillion per year.
What does all this mean for the new collateral space?
The dwindling number of AAA/AA entities, and above all, the potential correlations between borrowers and the collateral they are pledging, creates quite sharp mismatches between what looks like plenty (e.g. Eurozone government bonds), and the extent to which anyone wants to actually take them as collateral from a bank in the same country. Regulations remain in flux; for example, sub-AAA/AA issuance may likely be considered satisfactory collateral. Also, if there is demand, collateral transformation may increase the required supply. On the other hand, debt ceiling issues in the USA may entail a more reduced collateral supply in the form of US Treasuries or bills than was the case in the past.
The ECB still holds good collateral (Bunds, Dutch, French bonds and other AAA/
AA-rated securities). Although the fraction of good collateral has dropped since end-2011, the ECB’s €3 trillion balance sheet still holds about 20 percent in good collateral (or
€600 billion). The ECB may want to “rent” the good collateral that they hold, especially if their goal is to keep the good/bad collateral ratio high “in the markets.” So far, the ECB has accepted “not-so-good collateral,” and thus improved the good/bad collateral ratio in the market by decreasing the denominator. Renting of good collateral does not lower the numerator—the collateral is on loan temporarily. Other EU central banks also hold good collateral. Other central banks (e.g. SNB, UK) do not have the same vested interest as the ECB in propping up collateral markets in the EU. Interestingly, the Fed has started a reverse repo program that will supply collateral to both banks and non-banks.
In summary, the decrease in the “churning” of collateral may be significant, since there is demand from some SIFIs and/or their clients (asset managers, hedge funds, etc.) for “legally segregated/operationally commingled accounts” for the margin that they will post to CCPs. Post MF Global and Peregrine saga(s), there will be a decrease in the “reuse rate” of collateral, as there is increasing demand from several clients (asset managers, hedge funds, etc.) for “legally segregated” accounts. An excellent
market-based example is from the Reserve Bank of Australia (RBA). Their proposal manages to cope with the upcoming regulatory changes that will warrant significant, additional high-quality liquid assets (or good collateral) without issuing more debt securities, unlike discussions in some policy circles (e.g. Gourinchas/Jeanne, BIS paper).
This committed liquidity facility (CLF) is akin to paying a fee to get the guarantee of
This committed liquidity facility (CLF) is akin to paying a fee to get the guarantee of