At the end of 2016, some German and French bonds weren’t available at any price, and though March 2017 was better, the rising regulatory tide suggests these problems won’t go away any time soon.
There are two problems, really. The first is an absolute scarcity of collateral, borne of an ongoing imbalance between supply and demand.
The European Central Bank’s Public Sector Purchase Programme is holding about 25% of all outstanding European government bonds, and within this set, not all are useful collateral. On-the-run issues in core currencies at benchmark maturities are most important — off-market, high coupon legacy deals may be less so.
At the same time, regulation has driven absolute demand for collateral higher. Variation margin and initial margin rules for uncleared derivatives and the migration of much of the market into clearing houses means more banks need more collateral more of the time, while the migration of the unsecured funding market into secured format adds to the pressure.
But most of the time, the market continues to function, though perhaps with less liquidity than participants would like.
At quarter-end, though, the real problems kick in — and that is because of the actions of market intermediaries. In every company, quarter-end can mean a scramble to hit revenue and profit targets, but banks have to hit regulatory targets as well.
Rules on leverage, short term liquidity (the Liquidity Coverage Ratio) and upcoming rules on long-term liquidity (the Net Stable Funding Ratio) all make it more expensive for dealers to make active markets in repo. Some of these, in some countries, are calculated as average figures, but plenty of regulation looks at quarter-end balance sheets — including, for European firms, the ECB’s “SREP” calculation, which sets how much capital they need above their Pillar 1 minimum.
Investors, too, are looking in ever-greater detail at the creditworthiness of those they trade with, and borrow from, and companies are looking carefully at who holds their deposits.
Deutsche Bank’s reported $14bn of RMBS settlements in September meant huge outflows in prime brokerage and corporate deposits, which are only now being replaced, following an €8bn rights issue.
Being able to point to ample liquidity, therefore, is not just a regulatory imperative but a vital ingredient for doing certain kinds of business — and Deutsche and Credit Suisse alike learned the lesson, and held plenty of spare liquidity going into their RMBS settlements in December.
A quarter-end freeze in collateral markets is scary for repo traders, scary for central banks and scary for regulators, but it shouldn’t destabilise the market too much.
If a particular bank or dealer fails to deliver on a whole string of overnight trades, it should at least be able to cover the positions once markets ease in the new quarter, provided its counterparties can’t use this to force a default across all of its debt.
What is genuinely scary, though, is what’s being concealed by all of the quarter-end and year-end window dressing.
When regulators use this primped and preened balance sheet to set capital requirements for the rest of the quarter, they will demand too little of the institutions they monitor. At least, though, they are empowered to ask for more details, and push banks for live business data rather than public accounts.
Most market participants, though, must rely on quarterly numbers as the only chance they get to assess the financial strength of their counterparties, to prevent the leak of material non-public information.
If, market-wide, the only way everyone can look good is to freeze collateral markets, then which institutions look bad in between reporting periods?
Everyone has to suck their stomachs in to take the year-end snapshot — but who is displaying most muffin top when their counterparties aren’t looking?