Competing demands for high-quality collateral could increase costs and risks in global securities markets, according to a new report from the International Organisation of Securities Commissions (IOSCO).
The securities watchdogs’ body said that although levels in the financial system had remained stable to date, the range of competing demands risked reducing the availability of high-quality collateral and “could impact pricing”.
IOSCO cited the need of banks to hold high-quality collateral to meet capital requirements and the absorption of collateral by central banks to provide bank funding alongside the rising collateral requirements of buy- and sell-side market participants as more OTC derivatives moved to central clearing, in line with Group of 20 reforms.
The report also noted the increased use of various off-balance sheet practices – such as re-hypothecation and collateral transformation services – to optimise the use of available collateral, warning that a lack of disclosure on such transactions made it hard to assess their impact on systemic risk.
“Since this type of secure funding is inherently pro-cyclical, a negative shock to the financial system could be amplified and pose a risk to the stability of the financial system,” read the report, adding that regulators may “choose to assess this risk”.
The warnings came in IOSCO’s ‘Securities Markets Risk Outlook for 2013-2014’, a new annual publication aimed at identifying emerging risks that individual market regulators may need to take account of in their own jurisdictions.
In addition to concerns over collateral quality, costs and risk, the IOSCO report also characterised the migration of previously bilateral OTC derivatives – as mandated by the Dodd-Frank Act in the US and the European market infrastructure regulation in Europe – as “a challenging balancing act”.
The IOSCO report proposed regulators should remain alert to the risk that posted collateral levels could prove insufficient in the event of member default, if clearing houses accept too much lower quality level in a bid to attract members. It also noted work by the Dutch central bank which warned that use of similar risk management methodologies across clearing houses could leave members exposed to the same model risks in different markets.
The report also said the interconnectedness of clearing houses (also known as central counterparties or CCPs) could also pose a form of concentration risk. “Not only are many major banks members of CCPs, but initial margin collateral collected, particularly cash collateral, in some cases may be deposited back into the bank,” it read.
According to IOSCO, US$173 trillion of the US$633 trillion notional outstanding in OTC derivatives in 2012 was cleared.
Speaking at a press conference to launch the report, Greg Medcraft, chair of IOSCO and the Australian Securities and Investments Commission, observed: “In moving to solve one problem, one can create a whole set of new problems.”
IOSCO head of research Werner Bijkerk said the lack of transparency on re-hypothecation and collateral transformation transactions meant their risk to the financial system, particularly in times of stress, was hard to predict. He also warned about concentration of risk in CCPs as migration of OTC clearing gathered pace.
“CCP are beginning to be too big too fail,” he said. “Failure of a CCP could be catastrophic.”