- Manmohan Singh
- Published Date:
- June 2014
Collateral and Financial Plumbing
Collateral and Financial Plumbing
Published by Risk Books, a Division of Incisive Media Investments Ltd
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ISBN 978 1 78272 089 8
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For Komal and Kiran
About the Author
Manmohan Singh is a senior economist at the IMF. He writes extensively on topical issues including collateral and monetary policy, rehypothecation and velocity of collateral, deleveraging in financial markets, shadow banking, and counterparty risk in OTC derivatives. Singh has led the IMF’s workshops for official policymakers on strategic asset-allocation issues and the new financial regulatory framework. His articles have frequently appeared in the Financial Times, the Wall Street Journal, Euromoney, Risk, the Journal of Financial Infrastructures and other publications. His work experience covers several countries, including the UK, the US, Chile, India, Japan, Hungary, Poland, the Gulf countries and, more recently, peripheral Europe.
The financial crisis was a watershed for the way in which financial markets functioned and were regulated pre- and post-crisis. One of the most significant changes is the flight to security. The world of unsecure lending and uncollateralised trading clearly belongs to the past. This raises significant new challenges for the markets and their regulators
Collateral is a finite good. Nevertheless, legislators and regulators from across the world united in a flight to safety. As a consequence of the Basel Committee’s new bank capital requirements under Basel III and CPSS-IOSCO’s Financial Market Infrastructure Principles, financial counterparties, banks, clearing members and central counterparties are required to hold a far greater quantum of collateral than in the past to mitigate counterparty risk.
This gives rise to a number of fundamental issues:
- What is “eligible” collateral and who determines its status?
- How are we to deal with cross-border divergences?
- Even more importantly, is the quantum of eligible collateral in the system actually sufficient to meet the regulatory requirements, and is it even possible to quantify that amount?
Industry calculations diverge widely. Public authorities have generally produced significantly lower calculations. A further area of debate is the extent to which collateral is “reused” in the system. This has given rise to misunderstanding in the market due to the loose use of terminology that should distinguish more clearly between collateral that has changed legal ownership under title transfer and that which has not. The market mechanisms in this area have given rise to a new area of attention, often pejoratively dubbed “shadow banking”. Often misunderstood, this system of intermediation provides important liquidity to the market and has a vital role to play. Of course, greater transparency is required as a minimum, if only to increase the understanding of the “shadow banking” sector and to identify any risks that it may harbour.
The link between collateral used by “shadow banking” entities and monetary policy is another area that has seldom been explored in great depth. The repo market is directly affected by monetary-policy measures and can have implications for the connection between regulated firms and activities of the “shadow banking” sector.
As always, new business opportunities will arise for enterprising firms. “Collateral-transformation”, “collateral highways” and “collateral hubs” are being promoted by a variety of entities, from custodians to central counterparties, to meet increasing market demands for collateral. This will inevitably give rise to closer regulatory scrutiny. Greater transparency – meaning increased reporting – is usually the starting point for regulatory demands.
The most important regulatory concern with the plumbing of the financial system will remain a possible failure in one of its critical components. Global regulatory attention has now turned to the recovery and resolution of central counterparties. Collateral plays an important role in preventing, but also managing, problems in such systemically important infrastructures.
Manmohan Singh has been at the forefront of those who have raised the increasing importance of collateral and has, over the years, consistently sought attention for the challenges the dynamics of the new global financial architecture present.
This book considers all of these challenges – and more – and is intended as an important contribution to the debate and analysis of this complex topic. It is timely and brings many thoughtful insights to the challenges that lie ahead.
Patrick Pearson, June 2014.