Brookings on the Role of Collateral in Financial Markets
Brookings Institution
“Understanding the Role of Collateral in Financial Markets”
Monday, February 23, 2015
Key Topics & Takeaways
- Decrease in Collateral: IMF’s Singh stated that overall levels of collateral in the financial system have decreased due to the Fed’s QE programs, which have reduced collateral velocity.
- CCP Collateral: JPM’s O’Connor said that governance of eligible collateral held at CCPs “needs a more consistent approach” and that, if there is a market stress, the critical operations of the CCP must continue to function.
- Trade Compression: Stanford’s Duffie said that trade compression is a “legitimate method” of keeping counterparties safe while using less collateral.
- Regulatory Perspective: CFTC’s Srinivasan said there are a “spectrum of initiatives” that the CFTC is looking at in central clearing to reduce overall risk in financial system and that there is “a lot of time being spent” on more granular collateral issues.
Speakers
- Manmohan Singh, Senior Financial Economist, International Monetary Fund
- Sandra E. O’Connor, Chief Regulatory Affairs Officer, JP Morgan Chase & Co.
- Darrell Duffie, Professor of Finance, Stanford Graduate School of Business
- Sayee Srinivasan, Chief Economist, U.S. Commodity Futures Trading Commission
Presentation – Manmohan Singh
Manmohan Singh, Senior Financial Economist, International Monetary Fund (IMF), gave a presentation on how the amount of collateral in the financial markets has changed since the financial crisis, and how overall levels of collateral have been affected by the Federal Reserve’s (Fed) quantitative easing (QE) programs.
Singh explained that financial collateral can move across borders and is an integral part of “financial lubrication.” He said that QE has “interfered with the market plumbing” of collateral movement because the Fed has been “silo-ing” good collateral. He noted that the level of collateral at the major banks back in 2007 was around $10 trillion and declined to around $6 trillion by 2013. Singh noted that the approximately $3 trillion in new collateral held as assets in the Fed’s portfolio “does not move” and thus has reduced the “re-use rate” or “collateral velocity” in the marketplace from “about three to about two.”
Singh said that the term “shadow banking” has been used as a pejorative but said it is not a negative sector, adding that shadow banking will “grow by default” as regulators “trim the banking sector.” He also noted that hedge funds are the single biggest source of pledged collateral to the markets as “non-hedge fund sources” have been declining due to counterparty risk.
Since 2008, Singh stated, the money market has not been in sync with the repurchase (repo) markets and repo rates have not been in sync with the Fed Funds Rate. He also noted that excess reserves of banks are now “so large that they take up about a quarter” of banks’ balance sheets.
Question and Answer
Douglas J. Elliott, Brookings Fellow of Economic Studies and moderator, asked what the economic and social advantages are of analyzing collateral in the way Singh presented. Singh said that if regulators and policymakers do not “get a grasp” of the activities outside of the Fed’s flow of funds information, they will not be able to understand the interconnections between banks and non-banks.
A member of the audience asked if there is a problem or policy implication with the lower levels of collateral seen. Singh replied that he “wouldn’t say there are problems” but that it is important to shed light on what is happening in the market because “if everyone has to post margin” some of the market “may go to a place where they can cut corners.”
Another audience member asked if the lower collateral will reduce lending and who is ultimately impacted. Singh said the decreased collateral is “no different” than monetary tightening through increased interest rates and said it would raise borrowing costs for those in the marketplace.
The next audience question asked if there is a consequence for financial stability here that regulators do not see. Singh replied “no” and that he thinks regulators are “all very cognizant of the issues.”
Presentation – Sandra E. O’Connor
Sandra E. O’Connor, Chief Regulatory Affairs Officer, JP Morgan Chase & Co., explained that regulatory requirements for holding high quality liquid assets (HQLA) contribute to the reduction in collateral velocity, as these assets sit on banks’ balance sheets. However, she said that decreased velocity is “not necessarily bad” because it leads to a safer financial system and lending against collateral allows a bank to expand the number of counterparties it can deal with.
O’Connor said that collateral is “not all created equal” and that having the right amount of collateral under a stress scenario “really matters.” She noted that collateral should: 1) be able to liquefy under stress; 2) have reasonably transparent pricing and depth; 3) be subject to appropriate haircuts; and 4) must be readily available and not “rehypothecated away.”
O’Connor said that the governance of eligible collateral held at centralized counterparties (CCPs) “needs a more consistent approach” and that, if there is a market stress, the approach cannot be to liquidate the CCP’s collateral because the critical operations of the CCP must continue to function. O’Connor said that all collateral requirements should be pre-funded and that “tear-ups” and initial margin haircuts are “probably not the best solution” because they can lead to open hedges and create un-expected risk. She suggested that CCPs should have resolution plans that include re-capitalization.
Presentation – Darrell Duffie
Darrell Duffie, Professor of Finance, Stanford Graduate School of Business, said that the market needs to economize the amount of collateral available so that the same amount of financial services can be performed with less collateral. He then noted that a “slowing matriculation of assets” can have costs if they are tied up in collateral pools and said dealers bear a cost and are subject to a transfer of economic value from their shareholders to creditors when they provide collateral for swaps positions where their counterparty does not post collateral.
Duffie said there has been a shift among dealers to conduct more trade compression to eliminate notional exposure and thus reduce the amount of collateral needed for their positions. He said that trade compression is a “legitimate method” of keeping counterparties safe while using less collateral. He also noted that central clearing reduces the total amount of needed collateral, if it is assumed that all positions need collateral whether or not they are cleared. Duffie added that he sees central clearing of repos and securities lending “on the horizon.”
Presentation – Sayee Srinivasan
Sayee Srinivasan, Chief Economist, U.S. Commodity Futures Trading Commission (CFTC), said that regulations have been “driving crazy amounts of innovation,” especially in the post trade area. He noted that regulators “did not do a good enough job” of requiring submission of compression data and said that regulating CCPs is “still a work in progress.”
Srinivasan said there are a “spectrum of initiatives” that the CFTC is looking at in central clearing to reduce overall risk in financial system and that there is “a lot of time being spent” on more granular collateral issues including haircuts and types of collateral. He concluded that these issues are sometimes “painful” but that regulators need to “get it right” and stressed the importance of the CFTC working with the industry to obtain data on uncleared products.
Panel Question and Answer
Elliott asked how international regulatory coordination can work better. O’Connor replied that it will be important to have a combination of market and prudential regulators working on these issues and that some level of consistency on minimum standards should be achieved. She added that CCPs should not compete on risk management in a “race to the bottom” but should compete on the efficiencies they offer.
Elliott then asked if there is a shortage of high quality collateral in the financial system. Duffie said there is not a shortage and that supply and demand forces will converge “at a price.”
Elliott asked what areas the CFTC would like to see academics perform more research. Srinivasan said data on rates products has not been available until recently and said the CFTC has been encouraging people to do research with this data.
A member of the audience asked if CCPs have the potential to experience a “cataclysmic failure” due to operational risks, including technology glitches. Duffie said that while there is an “opportunity for operational risk,” CCPs are not as time sensitive as other markets, so a temporary shutdown in trading would not be cataclysmic. He said the most dangerous prospect for CCPs is the failure of one or more counterparties to meet their obligations and stressed that the “default waterfalls” in place must be robust, because central banks can only provide liquidity and not capital.
O’Connor followed up on Duffie’s response saying that keeping a CCP in operation is critical and that CCPs designated as systemically important financial institutions (SIFIs) should have the same obligations as other SIFIs. She added that CCPs should have enough “skin in the game” to align the interests of the CCP with the interests of its members and that clearing members should have a say in CCP governance protocols.
Another audience member asked if central banks will need to act as a market-maker of last resort, given the evolution of the marketplace. Duffie said “in no way should a central bank say they will act in that role” but said a central bank “will step in if they need to;” noting that the Fed acted this way in 2008. O’Connor added that central banks should only step in to provide liquidity for good assets and noted that haircuts can adjust for price volatility but not liquidity. Srinivasan said that regulators’ jobs are to ensure that the default waterfall is never needed.
For more information on this event, please click here.
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Brookings Institution
“Understanding the Role of Collateral in Financial Markets”
Monday, February 23, 2015
Key Topics & Takeaways
- Decrease in Collateral: IMF’s Singh stated that overall levels of collateral in the financial system have decreased due to the Fed’s QE programs, which have reduced collateral velocity.
- CCP Collateral: JPM’s O’Connor said that governance of eligible collateral held at CCPs “needs a more consistent approach” and that, if there is a market stress, the critical operations of the CCP must continue to function.
- Trade Compression: Stanford’s Duffie said that trade compression is a “legitimate method” of keeping counterparties safe while using less collateral.
- Regulatory Perspective: CFTC’s Srinivasan said there are a “spectrum of initiatives” that the CFTC is looking at in central clearing to reduce overall risk in financial system and that there is “a lot of time being spent” on more granular collateral issues.
Speakers
- Manmohan Singh, Senior Financial Economist, International Monetary Fund
- Sandra E. O’Connor, Chief Regulatory Affairs Officer, JP Morgan Chase & Co.
- Darrell Duffie, Professor of Finance, Stanford Graduate School of Business
- Sayee Srinivasan, Chief Economist, U.S. Commodity Futures Trading Commission
Presentation – Manmohan Singh
Manmohan Singh, Senior Financial Economist, International Monetary Fund (IMF), gave a presentation on how the amount of collateral in the financial markets has changed since the financial crisis, and how overall levels of collateral have been affected by the Federal Reserve’s (Fed) quantitative easing (QE) programs.
Singh explained that financial collateral can move across borders and is an integral part of “financial lubrication.” He said that QE has “interfered with the market plumbing” of collateral movement because the Fed has been “silo-ing” good collateral. He noted that the level of collateral at the major banks back in 2007 was around $10 trillion and declined to around $6 trillion by 2013. Singh noted that the approximately $3 trillion in new collateral held as assets in the Fed’s portfolio “does not move” and thus has reduced the “re-use rate” or “collateral velocity” in the marketplace from “about three to about two.”
Singh said that the term “shadow banking” has been used as a pejorative but said it is not a negative sector, adding that shadow banking will “grow by default” as regulators “trim the banking sector.” He also noted that hedge funds are the single biggest source of pledged collateral to the markets as “non-hedge fund sources” have been declining due to counterparty risk.
Since 2008, Singh stated, the money market has not been in sync with the repurchase (repo) markets and repo rates have not been in sync with the Fed Funds Rate. He also noted that excess reserves of banks are now “so large that they take up about a quarter” of banks’ balance sheets.
Question and Answer
Douglas J. Elliott, Brookings Fellow of Economic Studies and moderator, asked what the economic and social advantages are of analyzing collateral in the way Singh presented. Singh said that if regulators and policymakers do not “get a grasp” of the activities outside of the Fed’s flow of funds information, they will not be able to understand the interconnections between banks and non-banks.
A member of the audience asked if there is a problem or policy implication with the lower levels of collateral seen. Singh replied that he “wouldn’t say there are problems” but that it is important to shed light on what is happening in the market because “if everyone has to post margin” some of the market “may go to a place where they can cut corners.”
Another audience member asked if the lower collateral will reduce lending and who is ultimately impacted. Singh said the decreased collateral is “no different” than monetary tightening through increased interest rates and said it would raise borrowing costs for those in the marketplace.
The next audience question asked if there is a consequence for financial stability here that regulators do not see. Singh replied “no” and that he thinks regulators are “all very cognizant of the issues.”
Presentation – Sandra E. O’Connor
Sandra E. O’Connor, Chief Regulatory Affairs Officer, JP Morgan Chase & Co., explained that regulatory requirements for holding high quality liquid assets (HQLA) contribute to the reduction in collateral velocity, as these assets sit on banks’ balance sheets. However, she said that decreased velocity is “not necessarily bad” because it leads to a safer financial system and lending against collateral allows a bank to expand the number of counterparties it can deal with.
O’Connor said that collateral is “not all created equal” and that having the right amount of collateral under a stress scenario “really matters.” She noted that collateral should: 1) be able to liquefy under stress; 2) have reasonably transparent pricing and depth; 3) be subject to appropriate haircuts; and 4) must be readily available and not “rehypothecated away.”
O’Connor said that the governance of eligible collateral held at centralized counterparties (CCPs) “needs a more consistent approach” and that, if there is a market stress, the approach cannot be to liquidate the CCP’s collateral because the critical operations of the CCP must continue to function. O’Connor said that all collateral requirements should be pre-funded and that “tear-ups” and initial margin haircuts are “probably not the best solution” because they can lead to open hedges and create un-expected risk. She suggested that CCPs should have resolution plans that include re-capitalization.
Presentation – Darrell Duffie
Darrell Duffie, Professor of Finance, Stanford Graduate School of Business, said that the market needs to economize the amount of collateral available so that the same amount of financial services can be performed with less collateral. He then noted that a “slowing matriculation of assets” can have costs if they are tied up in collateral pools and said dealers bear a cost and are subject to a transfer of economic value from their shareholders to creditors when they provide collateral for swaps positions where their counterparty does not post collateral.
Duffie said there has been a shift among dealers to conduct more trade compression to eliminate notional exposure and thus reduce the amount of collateral needed for their positions. He said that trade compression is a “legitimate method” of keeping counterparties safe while using less collateral. He also noted that central clearing reduces the total amount of needed collateral, if it is assumed that all positions need collateral whether or not they are cleared. Duffie added that he sees central clearing of repos and securities lending “on the horizon.”
Presentation – Sayee Srinivasan
Sayee Srinivasan, Chief Economist, U.S. Commodity Futures Trading Commission (CFTC), said that regulations have been “driving crazy amounts of innovation,” especially in the post trade area. He noted that regulators “did not do a good enough job” of requiring submission of compression data and said that regulating CCPs is “still a work in progress.”
Srinivasan said there are a “spectrum of initiatives” that the CFTC is looking at in central clearing to reduce overall risk in financial system and that there is “a lot of time being spent” on more granular collateral issues including haircuts and types of collateral. He concluded that these issues are sometimes “painful” but that regulators need to “get it right” and stressed the importance of the CFTC working with the industry to obtain data on uncleared products.
Panel Question and Answer
Elliott asked how international regulatory coordination can work better. O’Connor replied that it will be important to have a combination of market and prudential regulators working on these issues and that some level of consistency on minimum standards should be achieved. She added that CCPs should not compete on risk management in a “race to the bottom” but should compete on the efficiencies they offer.
Elliott then asked if there is a shortage of high quality collateral in the financial system. Duffie said there is not a shortage and that supply and demand forces will converge “at a price.”
Elliott asked what areas the CFTC would like to see academics perform more research. Srinivasan said data on rates products has not been available until recently and said the CFTC has been encouraging people to do research with this data.
A member of the audience asked if CCPs have the potential to experience a “cataclysmic failure” due to operational risks, including technology glitches. Duffie said that while there is an “opportunity for operational risk,” CCPs are not as time sensitive as other markets, so a temporary shutdown in trading would not be cataclysmic. He said the most dangerous prospect for CCPs is the failure of one or more counterparties to meet their obligations and stressed that the “default waterfalls” in place must be robust, because central banks can only provide liquidity and not capital.
O’Connor followed up on Duffie’s response saying that keeping a CCP in operation is critical and that CCPs designated as systemically important financial institutions (SIFIs) should have the same obligations as other SIFIs. She added that CCPs should have enough “skin in the game” to align the interests of the CCP with the interests of its members and that clearing members should have a say in CCP governance protocols.
Another audience member asked if central banks will need to act as a market-maker of last resort, given the evolution of the marketplace. Duffie said “in no way should a central bank say they will act in that role” but said a central bank “will step in if they need to;” noting that the Fed acted this way in 2008. O’Connor added that central banks should only step in to provide liquidity for good assets and noted that haircuts can adjust for price volatility but not liquidity. Srinivasan said that regulators’ jobs are to ensure that the default waterfall is never needed.
For more information on this event, please click here.