Manmohan Singh
Published Date:
October 2016
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The book provides a practical understanding of how financial collateral moves across jurisdictions. The book complements the present thinking by drawing on the basic legal underpinnings of financial collateral, the sources and key players in this market, and how the size of this market is relevant from a monetary and macroeconomic perspective. More recently, central banks’ quantitative easing (QE) efforts have added another dimension to this book, since global financial lubrication comes from both money and financial collateral.

Since Lehman’s bankruptcy and the bailout of AIG, regulators have admitted several weaknesses in the financial system. Not surprisingly, the proposed regulatory agenda goes beyond the banks and now spans topics within the shadow banking world that include over-the-counter (OTC) derivatives; the non-bank institutions that are interconnected with large banks; markets, including repo and securities lending; money market mutual funds; etc. These activities are the nuts and bolts of financial plumbing, which is lubricated by collateral and money.

The book has two purposes. As well as striving to emphasise the importance of financial plumbing and the role of collateral, it sets out themes that we hope will be a useful guide to navigating the future, as rules and regulations for the global financial markets are redrawn.

The book is not intended to be mathematical or analytical, but will attempt to cover issues often overlooked by policymakers, academics and markets. The intuitive approach highlights that the pledged-collateral world spans many jurisdictions and so cannot be documented from the lens of one jurisdiction (or national accounts such as flow-of-funds). The book thus attempts to fill this void by providing several examples of how to augment the myopic thinking that stems from national data sources. Furthermore, most of the topics in this chapter embrace the shadow banking literature, which tends to be viewed somewhat negatively. However, the book attempts to overturn this myth and shed some light on the shadowy world of financial plumbing.

We expect to target a wide audience of senior professionals, including policymakers, banks, hedge funds, pensions, insurers, attorneys within the finance profession, and regulators who need to augment their understanding of financial plumbing. Every reader, with varying levels of experience in the field, will find a greater appreciation for the financial plumbing once they digest the basic concepts and grasp of how pledged collateral works and is an integral part (like money) of settling everyday debits/credits in the market. Some of those messages have reached the ears of key policymakers and we trust the book will continue to dispel some basic fallacies about financial plumbing and collateral. The book is forward-looking, since regulations that concern collateral issues (eg, Basel III, Dodd–Frank Act) are still being finalised at the time of writing. A few central banks are continuing with QE efforts (or variants thereof) and all that printed money that has replaced collateral will need to be addressed in due course.

This Introduction provides a summary of the book, and attempts to provide an angle on the world of finance that was already in existence, but not widely understood by many finance professionals.

Furthermore, this second impression (September 2016) is issued along with a special edition on “Collateral” by the Journal of Financial Markets Infrastructure (JFMI), that I lead-edited. The messages from papers within the JFMI special (from the Bank of England, Reserve Bank of Australia, Bundesbank, MIT, etc) resonate with the theme of this book. The market is the best signal: since the publication of the first edition of this book 2 years ago, several papers/dissertations have been written on rehypothecation, or related themes (eg, the FSB’s working group on collateral reuse, etc.)

Chapter 1 highlights the importance of financial collateral. The cross-border financial markets traditionally use “cash or cash-equivalent” (ie, money or highly liquid fungible securities) to settle accounts. Financial collateral does not have to be highly rated AAA/AA: as long as the securities (which can be either debt or equity) are liquid, mark-to-market and part of a legal cross-border master agreement, they can be used as “cash equivalent”. The chapter examines the accounting and legal interpretation of financial collateral and, by using hand-picked data from annual reports, shows that the financial collateral volumes are on par with money metrics.

Chapter 2 examines the financial collateral world within the context of its operational use. The collateral intermediation function is likely to become more important over time. The chapter looks at a new concept: collateral reuse (or velocity) in the market. Although there is sizeable issuance of good collateral, very little reaches the market. We describe how to measure this reuse rate and explain why this metric is increasingly important for policymakers to understand, especially when there is a shortage of collateral and monetary policy is stuck at zero lower bound.

Chapter 3 discusses the economics of how shadow banking meets financial intermediation, whereby non-banks interact with banks. The bank–non-bank nexus is largely seen as a form of regulatory arbitrage. However, this is an incomplete view, since there is genuine economic demand for such services. The chapter attempts to explain the economics that supports the demand and supply for this market, the systemic risks that can arise and regulatory and broader policy implications.

Chapter 4 deals with financial lubrication and monetary policy – the relative price(s) of money and collateral matter. Some central banks are now a major player in the collateral markets. Analogous to a coiled spring, the larger the QE efforts, the longer the central banks will have an impact on the collateral market and associated repo rate. This may have monetary-policy and financial-stability implications, since the repo rates map the financial landscape that straddles the bank–non-bank nexus.

Chapter 5 looks not only at money and collateral but also at the recent debate on safe assets. Between 1980 and the 2008 global financial crisis, the use of collateral in financial markets rose exponentially in the US and in other financial markets. After the crisis, we have seen a reduced pool of assets that are considered acceptable as collateral, resulting in a liquidity shortage. When trying to unwind QE, policymakers will need to consider collateral besides the traditional money metrics.

Chapter 6 looks at the role of collateral in the OTC derivative market and the sizable undercollateralisation in this market. There would be no need for central counterparties (CCPs) if everyone posted their share of collateral when using OTC derivatives. However, the proposed regulations concerned with moving most of this market to CCPs skirt the fundamental risk that resides in a bank – ie, its derivative liabilities (after netting). This is the cost to taxpayers from a large bank’s failure due to its derivative positions. As regulations do not force every contract to go to CCPs, a suggested alternative is to place a levy on the user or its bank (which may not wish to let go the business) with the primary objective that the bank’s derivative liabilities be minimised.

Chapter 7 provides a snapshot of the “changing collateral space” and how it may shape the global demand and supply for collateral. We identify the key collateral pools (relative to the “old” collateral space). Official sector efforts via QE have significantly altered the collateral space. Moreover, collateral movements will be further affected by regulatory demands stemming from Basel III, Dodd–Frank, EMIR, etc, as well as new debt issuance and collateral connectivity via global custodians.

Chapter 8 is about the global custodians such as Euroclear, Clearstream, Bank of New York (BoNY) and JPMorgan, who keep custody of the bulk of collateral (in trillions). This chapter explains the role of custodians, their business model and how they may impact the changing collateral space as the new regulations kick in. Furthermore, the chapter provides a good snapshot of the global market that is often found lacking due to regional biases. For example, in the US there is often discussion about triparty and related custody between BoNY, JPMorgan and perhaps State Street, but little coverage of European custodians (and vice versa).

Chapter 9 looks specifically at the role of collateral in the OTC derivative contracts between sovereigns and large banks. Due to the large volume of business (and associated revenue), most banks active in the collateral space do not actually force sovereigns to post collateral when the sovereigns are “out of the money” on their derivative contracts. However, if banks are indeed “out of the money”, they usually have to post collateral. The rhetoric about cutting the umbilical cord between banks and sovereigns will not get full traction unless sovereigns post collateral on their derivatives contracts with banks.

Chapter 10 asks what if there were a breakdown in the financial plumbing? Non-banks such as CCPs are perhaps the most useful lens to see how regulators view the role of financial plumbing. This chapter considers the options of keeping the CCPs afloat and the avenues available under the proposed regulations. It is argued that CCPs have, by regulatory fiat, become “too important to fail”, and thus the imperative should be greater loss-sharing by participants that better aligns the distribution of risks and rewards of CCPs, the clearing members and derivative end-users.

Chapter 11 highlights the Fed’s lift-off from “zero” in December 2015. The chapter reiterates that it is crucial to understand market signals such as repo rates since they have traditionally guided the policy rate. If the Fed increases its footprint in the financial plumbing, market signals will be weaker. Monetary policy transmission may be compromised if all short term rates do not move in sync.

Chapter 12 concludes with a forward-looking view as regulators finalise proposals in the near future and the financial landscape adjusts accordingly. The topics discussed will remain of immense interest and we hope that some of the key messages will not be overlooked.

Although this book attempts to simplify a complex topic, for this author it reflects a difficult personal journey. Very few – notably Stijn Claessens at the IMF, Phil Prince, James Aitken, Alastair Ryan, and a couple of individuals in the markets who wish to remain anonymous – have encouraged thinking “outside the box”. And it is at their request (and Risk’s initiative) that we decided to collate our thinking for the broader audience who would otherwise shy away from technical jargon. It is inevitable that there will be more financial crises, since this is the intrinsic nature of market systems. But, hopefully, we will adapt ourselves better as we move up the learning curve.

Views expressed in this book are those of the author and do not necessarily represent those of the IMF or IMF policy.

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