The expression ‘safe as houses’ is thought to have originated in England in the mid-19th century, following one of the world’s periodic investment manias (in this case focused on railway expansion). Following the usual misery for investors, bricks and mortar were promoted as tangible providers of long -term value.
For some reason, ‘safe as houses’ seems to have fallen out of use since 2008, but the desire for risk-free investment opportunities, even if never realised, remains as strong as ever.
Enter collateralisation. While the increase in demand for collateral is driven largely by regulation – in particular the promotion of central clearing for OTC derivatives – the belief that collateralisation is ‘a good thing’ is now widely held among lenders of all stripes, including central banks. In most cases, particularly when underpinning the efficiency of post-trade processes, this is true.
But the provision of collateral as a business opportunity may have unintended consequences. There is broad recognition that the demand for high quality collateral is likely to outstrip immediately available supply at some point in the next year. Differences exist on why that gap will arise. Some focus on the relative scarcity of appropriate assets; others on the siloes that prevent potential collateral from being in the right place at the right time.
Apart from improving the links that enable cross-border collateral flows, one of the generic solutions being promoted is the transformation, using repo and securities lending, of ineligible assets into pristine collateral (often cash in the case of central counterparties). We are assured that there is absolutely no alchemy involved in the process – a fear that industry professionals attribute to media scaremongering. And in the vast majority of situations, that again is true.
However, there are warning lights: if assets can be transformed by paying sufficient premium, how secure are the transformed assets in times of market stress? Can limits be placed on what assets can be fed into this process through multiple intermediation (the ‘horsemeat’ scenario)? Securitised credit claims are, for example, being spoken of as a potential additional source of collateral for margin calls. Sound familiar? Collateralisation – safe as houses.
Non-collateralised lending traditionally required the lender to make a judgment of the counterparty’s inherent solidity. In a collateralised world, will sufficient attention be paid to this? The problem is obviously not collateralisation per se. Clearly there are transactions – probably a majority – where increased collateralisation mitigates against risk. But when enthusiasm for an idea and the potential commercial opportunities it provides goes mainstream, it is perhaps time to pause for thought. If only markets could stand still once in a while…
By Richard Schwartz