A recent BIS report on “Developments in credit risk management across sectors:” raised some interesting points regarding the stability of the financial system. What I found interesting was the increasing use of collateral agreements and in particular higher quality/more liquid assets. If the financial system is exposed to a risk event there is a risk that this collateralisation of higher quality assets could increase the correlation of these assets to the risk event and may well end up drawing liquidity from other areas. Likewise as risk in the system increases the need to hedge and hence post collateral may further infect expected price reactions.
Over-the-counter (OTC) derivatives, both cleared and uncleared, are a significant source of credit risk…firms are increasing the amount of initial margin they collect from trading counterparties….
According to the survey results from supervisors and firms, the majority of supervisors and firms across all jurisdictions have observed increased margining activity in OTC derivatives markets since 2006….Supervisors and firms contend that this is the result of increased de-risking amongst firms because of the financial crisis (market situation) and regulatory reforms (eg the European Market Infrastructure Regulation (EMIR) in Europe, Dodd-Frank in the US and margining requirements on non-centrally cleared OTC derivatives).
The ISDA margin survey for 2014, for example, shows that 91% of all OTC derivatives trades (cleared and non-cleared) were subject to collateral agreements at the end of 2013.10.
The Joint Forum survey shows that supervisors and firms across all sectors and jurisdictions have observed not only an increase in collateralised transactions but also a demand that the collateral used for these transactions be of a higher quality and liquidity (eg cash and highly rated government bonds). This trend towards more (high-quality and liquid) collateralised transactions is seen not only in the OTC derivatives market but in all other transactions involving the use of collateral as well
In addition, more collateral swaps between institutions and an increase in the levels of over-collateralisation in securitisations have been observed
A margin risk highlighted by one firm (and one which could become a bigger issue as collateralisation activities increase) involves the liquidation value of the collateral posted as margin, which depends on the condition of the relevant market for that specific collateral. One firm said that it had observed disturbances in important markets for instruments posted as margin in recent years. The example it cited was the impact of the euro zone recession on real estate markets, in particular in the southern peripheral euro zone countries
Furthermore, firms have highlighted that they have observed increased interconnectivity of global financial institutions and potential systematic liquidity risk which needs to be taken into account to manage risks such as margin risks.
In summary, both supervisors and firms agree that collateralisation has been increasing since 2006. This is a result of new regulations requiring margin and of the market situation: due to the financial crisis, with firms such as Lehman Brothers failing, concerns over financial institutions’ creditworthiness have increased. As the new regulations requiring margin are either in their early stages or have not been implemented yet, and the market situation continues to be volatile, there is an expectation amongst firms and supervisors that the increased demand for margin will continue into at least the near future.
Supervisors and firms have both also observed that this increase in demand for margin is increasingly specifically focused on higher-quality and more liquid instruments (eg cash and highly rated government bonds). This increase in demand for higher-quality margin has led to concerns that shortages could emerge as more and more firms chase a finite amount of high-quality liquid margin. Current evidence from the marketplace and academic studies suggests that shortages are unlikely and that therefore any concerns are likely to be overstated. However, there is evidence that there may be structural and regulatory limitations within the system which can lead to available collateral posted as margin being immobilised in one part of the system, making it unattainable by creditworthy borrowers