Collateral Pledging Post-Lehman: How Reducing Counterparty Risk Squeezed Liquidity Manmohan Singh Senior Econo

1. 1 Collateral Pledging Post-Lehman: How Reducing Counterparty Risk Squeezed Liquidity Manmohan Singh Senior Economist Financial Sector Analysis Division Monetary & Capital Markets Department IMF

2. 2 CGFS study on collateral (BIS, March 2001) The use of collateral has become one of the most important and widespread risk mitigation techniques in wholesale financial markets.  Financial institutions extensively employ collateral in lending, in securities trading and derivatives markets and in payment and settlement systems. Central banks generally require collateral in their credit operations.

3. 3 CGFS study of 2001 …continued Over the last decade [1990-2000], the use of collateral in wholesale financial markets has grown rapidly. The collateral most commonly used and apparently preferred by market participants are instruments with inherently low credit and liquidity risks, namely government securities and cash. With the growth of collateral use so rapid, concern has been expressed that it could outstrip the growth of the effective supply of these preferred assets.  Scarcity of collateral could increase the cost of financial transactions, slow or inhibit financial activity and potentially encourage greater reliance on more inefficient non-price rationing mechanisms, such as restricting access to markets.

4. 4 These study suggest two questions for exploration.  The first is to what extent trends in the use of collateral and its supply have created or have the potential to create a relative scarcity of low risk, liquid collateral and, if such scarcity emerges, how markets could adjust.  The second is how such adjustment mechanisms and other changes in collateral usage might alter market dynamics and the risk management demands on financial institutions, particularly in stress periods.

5. 5 CGFS conclusions ( in 2001 !)Market participants could try to counter rising costs by making more efficient use of the existing stock of assets that serve as collateral and so increase the effective supply. Higher returns on securities loans could encourage institutional investors holding securities to make them available for securities lending (subject to regulatory or legal constraints)..Greater use of on-delivery or rehypothecation of collateral increases the velocity of the existing stock of collateral securities

6. 6 Counterparty Risk before and after Lehman

7. 7 Counterparty risk prior to Bear Stearns (see IMF WP 08/258 for more details for definition of counterparty risk)

8. 8 Recent Trends in Collateral Use (ISDA Margin Survey 2009)

9. 9 ISDA Margin Survey (2009):ISDA conducted its first survey of collateral use in the OTC derivatives industry in 2000. Since that time, the reported number of collateral agreements in place has grown from about 12,000 to almost 151,000, while the estimated amount of collateral in circulation has grown from about $200 billion to almost $4 trillion (estimated) at the end of 2009. This is up from an estimated $2.1 trillion at the end of 2008. In addition, there has been a continuing trend toward increased collateral coverage, in terms of both number of trades and amount of credit exposure.

10. 10 ISDA Margin Survey…continuedCash continues to grow in importance among most firms, and now stands at almost 84 percent of collateral received and 83 percent of collateral delivered. The use of government securities as collateral also grew last year. The increase in cash and government securities was balanced by a decline in the use of other forms of collateral such as corporate bonds and equities

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13. 13 Securities Lending by leading custodians and Rehypothecation by major banks

14. 14 Securities lending by custodians(billions of dollars)

15. 15 Securities lending by custodians(billions of dollars)Mar 30 2009

16. 16 Rehypothecation The ability of a prime broker to use client assets posted as collateral to that prime broker for the prime broker’s own purposes. Ps: It’s is not something that started over the late, now unlamented credit cycle..

17. 17 The New York Times, March 5, 1878. The exclusive announcement in Sunday's TIMES that the banking and brokerage firm of Greenleaf, Norris Co. had been placed in the hands of Seiah Chamberlain, as Receiver, on the latter's affidavit that the firm had rehypothecated large amounts of securities deposited with them by other persons, as security for the repayment of loans obtained by them in their own name, and, that in this rehypothecation the securities had been mingled together, thus rendering it a very difficult task for the owners of the pledged securities to obtain their own property, created a sensation on the street yesterday. 

18. 18 Fair value of securities received as collateral, which can be pledged(billions of dollars) 

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22. 22 Lehman – what the client can see  LBI

23. 23 Securities Investor Protection Act

24. 24 Rehypothecation in the UK and US

25. 25 Segregated accounts used in a broad sense and includes: Sweeping non-collateral assets into custody accounts Restricting rehypothecation rights Using multiple prime-brokerages Applying for client money protection under FSA’s Client Money Rules

26. 26 Lehman’s bankruptcy

27. 27 Rehypothecation and Repo markets

28. 28 Counterparty Risk, Deleveraging and impact on Collateral use

29. 29 Counterparty risk and Deleveraging

30. 30 Supply and Demand for CollateralThe terminal event for Bear Stearns, Lehman was that they ranout of pledge-able, unencumbered collateral. If the fair value of securities received as collateral coming into a financial institution is decreasing, and at the same time they are being obliged to post more and more to their counterparties.....it gets very uncomfortable. 

31. 31 Liquidity buffers are increasingEnormous liquidity buffers of cash and high-grade, short-duration highly-liquid government bond collateral. From Goldman Sachs’ most recent 10-Q, page 135: Our most important liquidity policy is to pre-fund what we estimate will be our likely cash needs during a liquidity crisis and hold such excess liquidity in the form of unencumbered, highly liquid securities that may be sold or pledged to provide same-day liquidity

32. 32 GS recent 10Q… continued The U.S. dollar-denominated excess is comprised of only unencumbered U.S. Government securities, U.S. agency securities and highly liquid U.S. agency mortgage-backed securities, all of which are eligible as collateral in Federal Reserve open market operations, as well as overnight cashdeposits.  Our non-U.S. dollar-denominated excess is comprised of only unencumbered French, German, United Kingdom and Japanese government bonds and overnight cash deposits in highly liquid currencies.

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34. 34 Think of it as $1.5 trillion of risk capital and balance sheet capacity that may have otherwise been applied to proprietary trading, market-making and arbitrage activities (e.g. negative basis trades in credit).

35. 35 Systemic impact and conclusions

36. 36 We operate in a collateralised financial systemAs evidenced by the 2009 ISDA Margin Survey, the amount of collateral agreements supporting OTC derivatives is going up, the amount of collateral in circulation (required) is going up even faster. Post Lehman, clients are sensibly paying closer attention to collateral management (e.g. banning rehypothecation, putting all collateral in a segregated accounts etc)Brevan Howard (latest Annual Investment Manager Review): “We limit the rights of prime brokers to rehypothecate our securities. We move our cash balances away from our prime brokers to segregated custody accounts at third parties”Very unlikely that securities lending goes to zero, but will rehypothecation remain the same in the future? (especially in UK)

37. 37 To truly stabilise the financial system, the velocity of collateral has to stabilise and turn higher once more Somebody (new) has to start posting collateral, rather than just receiving it or demanding it from counterparties under the terms of privately-negotiated credit support annexes. 

38. 38 Final thoughts , from New York Fed Working Paper No. 360 (Adrian/Shin)In a hypothetical world where deposit-taking banks are the only financial intermediaries, their liabilities as measured by traditional monetary aggregates—such as M2—would be good indicators the aggregate size of the balance sheets of leveraged institutions.Instead, the authors emphasise market-based liabilities such as repos and commercial paper as better indicators of credit conditions that influence the economy (see next chart that shows reduction on repos & CP)

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40. 40 thank youcomments welcome via msingh@imf.org