There has been a strong upward trend in collateralization since the great financial crisis. Suitable collateral, such as government bonds, is essential for financial transactions, particularly repurchase agreements and derivative contracts. Increased collateralization poses new risks. Collateral prices and haircuts are pro-cyclical, which means that collateralized transactions flourish when assets values rise and slump when asset values decline. This creates links between leverage, asset prices, hedging costs and liquidity across many markets. Trends are mutually reinforcing and can escalate into fire sales and market paralysis. Central clearing cannot eliminate this escalation risk. The collateral policies of central banks have become more important.
The post ties in with SRSV’s lecture on the shadow banking system and non-conventional monetary policy.
The below are excerpts from the paper. Emphasis and cursive text have been added.
The purpose of collateralization
“Collateralisation addresses asymmetric information and moral hazard problems in the economy…In its most basic form, collateral is an asset that a borrower offers a lender to secure a loan. The lender has the right to take possession of the collateral if the borrower defaults on the loan.”
“There are three main reasons why contracting parties demand collateral.
- First, being able to take possession of an asset gives the lender the opportunity to receive some payment in case of the borrower’s default…
- A second role of collateral is the improvement of borrower incentives to repay the loan. In many cases the probability of borrower default is endogenous (moral hazard). Posting collateral has the potential to reward good behaviour and punish bad behaviour…
- A…third role of collateral is the signalling financial strength… a borrower can signal a high likelihood of repayment by posting collateral.”
“The cost of using collateral and the conditional transfer of collateral in default go hand in hand…The quality of collateral is defined by its safety and its liquidity… i.e., there is little loss of value when the asset is transferred from a defaulted borrower to his lender…Liquid collateral also does not require maintenance and is transparent (easy to value).”
“An asset is good collateral when it is robust to borrower default… The house securing a mortgage may not be good collateral if the value of the house is correlated with the borrower losing his job. Such a correlation happens, for example, when an entire economic area is hit by a negative shock.”
Collateralization in financial markets
“In the aftermath of the global financial crisis, as well as the European sovereign debt crisis, there has been a strong upward trend in the use of collateral to back up financial transactions. Prior to 2007, around 60% of the turnover in euro money markets was secured. By 2015, this share has increased to 90%.”
“The basic logic [of collateralization] applies in the case of financial collateral assets. But the issue of financial collateral is much richer. In financial markets, agents often borrow the asset instead of cash. It also is much easier to modify who has control over an asset when it is a financial rather than a real one. Moreover, collateral appears not just in lending but also in hedging. Margins are collateral in the context of derivatives.”
“The relative size of the loan volume and the value of the collateral (the assets sold and repurchased) define the haircut or margin required. The haircut is given by 1-(loan volume/value of collateral), while the margin is given by (value of collateral/loan volume)-1. If a borrower has to post collateral worth 100 to borrow 80, then there is a 20% (0.2=1-80/100) haircut and a 25% margin (0.25=100/80-1). If the borrower is able to borrow 90, then the haircut falls to 10% and the margin falls to 11%. The haircut can be compared to a down-payment… The haircut should therefore reflect borrower risk and asset re-deployability.”
“[There are two major transactions that use financial collateral:]
- In a repo transaction, the borrower sells the asset to the lender for cash and, at the same time, acquires the right to repurchase the asset at the original price plus an extra amount at a prespecified future date… Even though a repo contract functions much like a secured loan… extra issues typically arise…Normally, in a secured loan the borrower has control of the collateral asset as long as he does not default. In a repo contract the lender typically has control of the collateral asset until it is repurchased by the borrower. Hence, the lender can use the asset as she pleases until she has to return it to the borrower. This process of re-using the collateral asset is called re-hypothecation.
- Margins are collateral in the context of derivative The insurance provided by derivative contracts is effective only when counterparties honour their contractual obligations, i.e., when there is no counterparty default. In order to protect against default, counterparties call margins… Derivative positions are evaluated not just at the end of the contract but also during the life of the contract (mark-to-market)…Posting collateral [continuously in accordance with underlying price changes]…protects the insured against counterparty risk as soon as the derivative position turns into an expected liability.”
“Private markets can produce collateral, but the supply of high-quality private collateral is necessarily limited by the very asymmetric information and moral hazard problems collateral is supposed to address…Given the scarcity of private high-quality collateral, there is a role for the government to expand the supply of high-quality collateral by issuing government debt… government debt typically is safe and liquid, and serves as high-quality collateral that expands the scope of private financial transactions.”
“The market appears to attach a premium to government bonds because they are good collateral…The supply of safe and liquid government bonds enhances the making of financial transactions—such bonds perform a similar function as money does for real transactions… High-quality collateral, especially the one supplied in the form of government bonds, is in high demand in the private market when there is stress in the financial system.”
On the relation between collateralized transaction and shadow banking view post here.
New financial stability risk
“Given the control right to the lender increases the effective liquidity of collateral asset,…But it may lead to too much asset sales from the point of view of the economy as a whole. As lenders quickly sell collateral assets, the price of these assets falls as the supply to the market increases. Such a ‘fire-sale’ may have adverse consequences for market participants…the externality may be more severe for repos than for other forms of secured lending because of the exemption from automatic stay [exemption from automatic injunction that halts actions by creditors].”
“Collateral and margin requirements set by market participants may be pro-cyclical, with low collateral and margin requirements in good times and large – and potentially sudden – increases in the collateral and margin requirements in periods of market turbulence… Low collateral and margin requirements allow for higher leverage. Therefore, pro-cyclicality of collateral and margin requirements goes hand in hand with pro-cyclicality of leverage in the financial sector. And leverage can have large amplifications effects on the macroeconomy: small, temporary shocks to technology or income distribution can generate large, persistent fluctuations in output and asset prices.”
- “There is empirical evidence that marked-to-market leverage is indeed strongly pro-cyclical… In particular, those financial intermediaries whose net worth is sensitive to fluctuations in asset prices actively adjust their balance sheets to changes in their net worth, and do so in such a way that leverage is high during booms and low during busts. The leverage is financed primarily through borrowing in secured, repo markets. That is, an important source of pro-cyclicality is the link between leverage and asset prices.”
- “When bad shocks hit the economy, margins increase, asset prices fall and volatility increases. This generates losses for the most optimistic, leveraged investors. The feedbacks between volatility, tightening margin constraints and losses by highly leveraged investors further amplify the negative effects on asset prices. This dynamics gives rise to the so-called ‘leverage cycles’.”
- “Moreover, adverse shocks to funding liquidity and market liquidity can become mutually reinforcing…An initial adverse shock to asset prices can be amplified if potential buyers of assets are collateral-constrained and falling asset prices tighten their constraints further. Reduced market liquidity leads to even lower asset prices and increased volatility, triggering further margin calls and creating a negative feedback loop between tightening funding constraints and asset prices.”
On the relation between collateral and liquidity view post here.
On liquidity spirals in money markets view post here.
“Pro-cyclicality affects not only funding markets but also markets for hedging risk through derivatives. Derivatives contracts with large exposures and higher counterparty risk are more likely to be underwritten in good times when the perceived macroeconomic risk is low and adverse shocks seem unlikely… In the context of derivatives markets, margin calls provide insurance against counterparty default and when margin calls are made, assets are liquidated to satisfy them. Low expected asset prices imply that a large amount of assets must be liquidated to provide enough insurance. “
The role of central clearing counterparties (CCPs)
“When a transaction is brought to a CCP for clearing, the CCP interposes between contracting parties. For example, in the context of a CDS contract, the original contract between a protection buyer and a protection seller is transformed into two contracts, one between the seller and the CCP and another one between the buyer and the CCP (a process called novation). Importantly, if one of the counterparties is unable to meet its obligations to the other, the clearing entity makes the payment on behalf of the defaulting party.”
“There are several reasons why centralised clearing can be superior to decentralised clearing. The reasons include: [1] mutualisation of counterparty risk; [2] saving on collateral and settlement costs; [3] enhanced transparency; and [4] optimal setting of contracts and margins.”
“Central clearing does not eliminate risks in financial contracting. Instead, it re-allocates risk from contracting parties to the CCP as the CCP interposes between counterparties, and concentrates large amounts of risk in a single entity (or a few big entities). Such re-allocation of risk may by itself alter incentives of contracting parties. Furthermore, the concentration of risk makes CCPs systemically important institutions which may affect incentives of CCPs for prudent behaviour. Also, greater use of CCPs means greater reliance on a limited range of risk-management practices, which may synchronise reactions to shocks and have pro-cyclical effects on financial markets and financial system at large.”
On central clearing and systemic risk view post here.
Consequences for monetary policy
“The design and implementation of central bank operating frameworks, as well as non-standard monetary policy in the form of large-scale asset purchases have become critical for the working of secured markets. We present evidence for the significant influence of Eurosystem eligibility criteria and collateral haircuts, especially relative to CCP haircuts, on markets involving collateral assets.”
On the collateral channel of monetary policy view post here.
“Central bank operations can improve liquidity and market functioning. However, they can also withdraw collateral assets, which may contribute to a scarcity of good collateral and to the ‘specialness’ of some assets or asset classes…For example, a central bank that is providing liquidity to the financial system will typically either take collateral or purchase assets outright – so that, in either case, the central bank liquidity provided may be partly offset by a reduction in the stock of assets available for use as collateral in private transactions, such as repos… The latter may become a growing concern as the Eurosystem continues to increase its public sector securities holdings.”
“Central bank actions can impact collateral markets mainly through a scarcity and a structural channel. Structural effects mainly include effects from the designation of eligible securities. A decision to accept a type of asset as collateral in a central bank operation will affect its pledgeability, inducing an increased willingness from issuers to issue these assets and from counterparties to hold them on the balance sheet.”
“Because public debt is good collateral, such ‘extra liquidity’ may not be distributed efficiently in the economy, especially in times of crisis (in so-called “flight-to-quality” episodes). Uncertainty, market power or symmetric information problems may lead to an inefficient hoarding of liquidity by some. In these circumstances, there is a role for central banks to overcome coordination failures among private agents and to ensure an efficient distribution of liquidity in the financial system.”
