Spare a Dime?

What is the size of the available global collateral pool?

What is the size of the available global collateral pool? In reality, both estimates of supply and demand suffer from the opaque nature of the fast-changing and far-reaching world of collateralised risk. In the latest edition of Global Custodian, one of the largest U.K. superannuation schemes noted they hold $50 billion of prime assets, and some of those could be available for collateral pools. Conversely, there are reports that the EU will limit the rehypothecation, by prime brokers, of hedge fund assets, with a cap being discussed of between 125-140% of fund net debt rather than the unlimited cap that currently prevails. That, and the other strictures of the AIFMD, would reduce collateral supply.

The reality is that manifest problems remain in the collateral world. There is a long-term imbalance between demand and supply. And then there are three related issues: availability, cost and dependability.

There are allegedly around $120 trillion of assets under custody. As that figure is reached by aggregating the declared asset figures of the different custodians, there is undoubtedly some double counting and perhaps a certain amount of commercial exaggeration. Global equity capitalization, according to the World Federation of Stock Exchanges, stands at around $50 trillion, and around 75% of such assets may be held by global custodians for institutional and corporate clients. That leaves perhaps close to $75 trillion dollars of fixed, floating or similar instruments, of which only a small subset is both available and readily eligible for the collateral pool at any point in time.

However, the final net figure for maximum collateral availability is dwarfed by the demand drivers. The latest BIS triennial survey of open OTC derivative positions shows notional amounts outstanding at $583 trillion, with the replacement cost of such contracts estimated at $25 trillion. The sheer volumes of the OTC market, allied to the collateral demands of the National Central Bank community, the rise in secured bank finance in general and the liens (and related freezes) in different settlement systems mean that global demand will, in the not-too-distant future, far exceed availability. After all, a recent BIS study showed that the collateral demand for initial margin on IRS and CDS transactions to be cleared through CCPs, post Dodd-Frank and EMIR, by the G14 major dealers alone would be well in excess of a trillion dollars. Other unofficial estimates put the aggregate initial and variation margin demands from CCPs in that brave new world at a substantially higher figure.

In part, the shortfall is being tackled by the growing use of covered bonds (bringing in mortgage and other non-marketable debt into the collateral pool) and by the acceptance of similar such security by the national central banks (and the ECB). But that only meets part of the growing challenge of collateral paucity. Increased market risk means more and more exposures are being collateralized. Increased market volatility means that initial and variation margin will increase relative to the open position over time.

Excess demand means there are two options for the marketplace: Contract the open position or change supply. The former appears more likely than the latter, as supply can only change by adopting laxer risk policies. That would imply accepting even more volatile or less marketable collateral. That appears to be impossible in an age where we are migrating from bilateral assessment of risk (through often bespoke OTC transactions) to centrally cleared and more standardized instruments in a much more dirigiste environment. On the supply side, a recovery of world economies would allow some of those national debt mountains to remain (or become) graded at AAA, but the beneficial effects of such a change would inevitably be accompanied by a slowdown, or decline, in government debt issuance. The collateral highway, and other initiatives, will improve access, whether through tri-party arrangements, instrument swaps or other structures, but it would be amazing if that released even a trillion dollars of added collateral over the current decade. Cash remains an in-demand collateral play, but, especially in the investor market, it is far from favored given the poor returns earned from the takers.

Logically, as demand will exceed supply, cost will increase. The big question is by how much. It is hard to assess risks in the collateral management field. Lenders of prime instruments, even against cash collateral, should note that most banks have taken loan losses through misjudgment of the value of their collateral. Unwinding a position is as dependent, in times of stress, on the counterparty as on the collateral. The collateral (assuming all legal risks are covered) is a risk mitigator and not automatically a risk eliminator.

And one should not forget the killer punch. If a crisis happens overnight, collateral providers will scramble to recover their assets. If the crisis happens gradually, their risk appetite will decrease as the markets deteriorate. The systemic risk arises when we get hooked on collateral. History shows that collateral disappears at the time it is most needed.

Perhaps the only solution is going to be a major reduction in at-risk positions. That will provide both economies and market players with their biggest challenge yet.

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