Regulators are the only bodies with the authority to say what is safe collateral and what is not. They have focused on the idea of high quality collateral — an asset which is liquid and has a cash market that supports it. This has created a connection between banks and sovereign markets which is now stronger than it ever has been.
A number of regulations such as the liquidity coverage ratio, net stable funding ratio (NSFR), leverage ratio and newly introduced derivatives rules calling for swap counterparties to set aside initial and variation margins have created demands for specific types of collateral that regulators deem safe.
The European Central Bank’s asset purchase programme has also ramped up demand for these assets. This has caused one of the most liquid European instruments of all, German two year government bonds, to rise to their most expensive level ever with the result that yields are now back at their all-time low of minus 0.80%. The ECB currently owns about 27% of all outstanding German government bonds alongside big chunks of other European sovereign debt.
The shortage of collateral this has created is seen in the high and rising number of bonds accepted as general collateral which have begun to trade ‘special’ in the repo market.
Calendar crunch
Bonds that trade special have been trending higher over a long period but the key flash points, where demand for collateral is highest, are at the end of each quarter and the end of the year.
The last peak, when the repo market seized up, came at the end of 2016 when demand for HQLA far exceeded historic periods of instability such as Lehman’s collapse in 2008 or the eurozone sovereign debt crisis that followed.
One way to cheapen the cost of collateral, or at least smooth its price, is to allow users to leverage the collateral they hold. But with most European banks still striving to lower leverage, the cost of collateral can only rise in tandem with demand.
Europe’s lower rated banks, which are deleveraging more rapidly, who are more challenged in terms of their capital needs and whose participation in European repo market had dropped the most, feel the pinch the most.
But the buy-side, which relies on banks to find collateral, is also experiencing severe difficulties . Banks that all but shit down for business over the end of the quarter or year don’t want investors' cash. That means investors go to the T-Bill market where they are forced to pay very high negative rates of return.
This problem was epitomised in a letter written by the Dutch pension fund PGGM on behalf of the pension fund industry in January 2016 to the then European Commissioner Jonathan Hill.
PGGM expressed deep concern over liquidity demands, particularly with regard to the European Market Infrastructure Regulation and the increasing requirement for central clearing of derivatives. This, it said, had led to costly restrictions on pension funds' asset liability management strategies, and created liquidity bottlenecks around the end of the year.
Members of the repo industry has proposed several measures that could help to alleviate the situation, which they are convinced will only get worse.
One solution is to follow the example of the US Federal Reserve by instigating overnight reverse repo facilities with the buy-side. They also suggest harmonisation of legal agreements between all of Europe’s national central banks. They say that the NSFR could be tweaked as its asymmetric bias does not permit bank lending for less than six months, while in contrast money market funds can only borrow for up to one week.
These and a lot of other practical steps could be taken by the European Commission and the ECB to make matters less dangerous. But for this to happen the various heads of department need to get together and look at the problem in a holistic way as changing only one thing is unlikely to work.
The industry has given clear warning that if the pipework that delivers liquidity is not soon fixed it will probably seize up causing considerable repurcussions for the financial industry as a whole.
There is no sense in waiting.