Inside investment: The collateral crunch
Regulators are beginning to express concerns about a potential collateral crunch causing a new market seizure. One solution might be to increase the use of SDRs.
Once upon a lifetime ago one of my very first jobs at Euromoney involved helping with the launch of a quarterly magazine on the collateralized funding and securities lending markets. It was pretty arcane stuff for a history graduate to be delving into. Back then repos (repurchase agreements) were only just taking hold in Europe. The only people who understood their workings were highly paid product specialists and less-well-remunerated journalists.
At some point in the noughties (my attention was elsewhere by then) these products became screen-based and commoditized. They were part of the plumbing. Then along came the crisis. Collateral and its use, abuse and, most importantly, re-use was centre stage. Plumbing, you see, is important. The collapse of Lehman caused a nasty back-up in the system.
Extended collateral chains of bonds and cash were severed and withdrawn because no one trusted their counterparties. This caused the great trading money-go-round that finances broker-dealers and hedge funds to grind to a shuddering halt. Liquidity collapsed, so even non-leveraged investors could not get business done. The bid-offer spread, on everything from cash bonds through to exotic options, gapped. The inherent fragility of the financial system was laid bare.
Since those dark days, regulators have been engaged in an effort to build greater resilience. One of the most important building blocks of this new financial architecture is collateral. The demand that OTC derivatives be cleared through central counterparties means that initial and variation margin will need to be posted. This collateral generally comes in the form of cash or high-quality bonds, the same securities used in repo and securities lending markets.
The International Swaps and Derivatives Association has estimated that additional demands on collateral globally could be as much as $10 trillion. This has raised concerns of a collateral crunch. The European Securities and Markets Authority addressed this issue directly in its recent Trends, Risk and Vulnerabilities report. It says: "In view of the potential financial stability risks linked to relative collateral scarcity, the availability and use of collateral needs to be monitored."
This is one of the odder unintended consequences of regulation and all routes lead back to the crisis. The lack of high-quality securities is partly because of the knock-on effects of governments bailing out banks and increasing their own indebtedness and bond issuance. In sovereign bond markets, AA is the new triple-A. But some of those new AAs are also on credit watch. Norway is not about to issue enough bonds to bridge the gap.
Of SDRs and RMBs
Since we are delving around in relatively esoteric parts of global finance, let’s turn next to SDRs (special drawing rights). Strictly speaking the SDR is not a currency, rather a claim on member central banks maintained by the IMF. But it is a quasi-currency. In 2011 the IMF issued a paper, Enhancing International Monetary Stability – A Role for the SDR. It raised the prospect of issuing bonds in SDRs as a means of financing the IMF.
As the paper points out, there is a precedent for bond issuance in a quasi-currency, the ECU. This is attractive at many levels. First, boosting the firepower of the IMF makes good sense. The one thing we all should have learnt from 2008 is that we do not know where the next crisis is coming from. At one point in 2012, after the downgrade of the European Financial Stability Facility and surge in euro payments system (Target2) imbalances, this theoretical possibility briefly rose up the agenda.
What is certain is that SDR-denominated bonds would be triple-A rated. As such they would be in huge demand, for several reasons. One has already been stated: triple-A is becoming as rare as hen’s teeth. But there are other, subtler and interrelated, explanations. The likely biggest buyers of these bonds are asset pools that care most about return of capital – in particular, reserve managers at central banks and sovereign wealth funds. These entities are also looking for a way to diversify their large US dollar holdings.
There is a small snag. The SDR is not as diversifying as it might be. It is made up of a currency basket of US dollar, euro, yen, and sterling. The dollar is 41.9% of the basket. If you add in sterling, the basket is more than 50% composed of net debtors. The eurozone is broadly in balance. By contrast, China has a net foreign asset position of more than 50% of GDP. In 2009 the chairman of the People’s Bank of China, Zhou Xiaochuan, called for the SDR to become a new global reserve currency. Implicit in his comment was the inclusion of the renminbi in the SDR basket. The next review of its constituents is in 2015.
Much can be achieved in two years. At the very least, the IMF would want to see far greater opening of the Chinese current account and a shake-up of domestic interest rate markets. But given China’s ever-increasing pile of dollars this must make sense to the new regime. A careful recalibration of the SDR and its broader use could also have collateral benefits for the entire financial system.
Andrew Capon has won multiple awards for commentary and journalism on markets, investment and asset management. He welcomes comments from readers and can be reached at email@example.com