While a global shortage of collateral is unlikely, satisfying future demand could still remain problematic, according to an academic study by the London School of Economics (LSE).
Ronald Anderson and Karin Jõeveer, authors of ‘The Economics of Collateral’, described the possibility of emerging bottlenecks that might mean the immobilisation of available collateral in one part of the market, making it unavailable to credit-worthy borrowers.
Though the report, which was commissioned by the Depository Trust and Clearing Corporation, is confident there will be an appropriate quantity of collateral despite post-crisis demands for more and better collateral, the authors suggest that market participant activity and regulatory reform since 2007-2008 may in fact limit the accessibility of collateral in the long run.
As a result of the financial crisis there has been a surge in demand for safety and security, increasing the use of reliable collateral to support the transactions. In response, major banks have since focused their funding more towards secured debt and this has been exacerbated by equivalent regulatory reform such as Basel III, Dodd-Frank in the United States and the European market infrastructure regulation.
The introduction of regulations such as the liquidity coverage ratio and the net stable funding ratio has led to immense increases in the levels of high-quality, liquid assets held by banks. Combined with the credit valuation adjustment risk capital charge against counterparty credit risks introduced under the revised capital adequacy framework in 2010-11, there has been a substantial move towards centralised trading platforms and mandatory central counterparties in recent years.
Anderson and Jõeveer show that these changes are likely to facilitate collateral immobilisation in one part of the system, and a failure to meet collateral demands in another. In this way the authors observe that “the notion that greater reliance on collateral will eliminate credit risk is illusory.” As such, Professor Anderson explains that “the search for new methods to alleviate bottlenecks and seamlessly allocate collateral is the next challenge for infrastructure providers and participants” and “collaboration between participants and infrastructure providers will be crucial to ensuring an efficient process.”
As Godfried de Vidts, Chairman of the International Capital Markets Association’s European Repo Council, notes, “We are at a cross-roads as an industry, where collateral is available to satisfy counterparty and regulator needs, yet credit-worthy borrower access could become threatened due to scalability issues related to an increase in margin calls and a lack of standardised global solutions across markets and firms. Now is the time that the industry must work together to ensure streamlined access to collateral worldwide.”