In a dark, dark market
29 March 2016
Is the so-called collateral shortfall a result of asset hoarding, excessive regulation, or simply a tall tale told to young bankers before bedtime?
Image: Shutterstock
Is the liquidity crisis reality or fiction?
Scot Warren
Executive vice president of business development
OCC and the Options Industry Council
From OCC鈥檚 perspective as a central counterparty (CCP), we are seeing increased capital requirements affecting market behaviour. Due to their increased capital requirements, clearing firms are being more stringent with the credit they extend to liquidity providers and the balance they are allowed to hold. In turn, liquidity providers display less liquidity in the market. For other market participants, lower liquidity levels increase their implementation costs, therefore reducing the value of using CCP-cleared products. Diminished value for investors leads to lower demand for listed products.
Additionally, for CCP鈥檚 the cost of securing committed credit facilities is increasing and has become more challenging due to being included in single counterparty exposure limits. As a result, OCC is pioneering paths to finding new sources of liquidity by working with public pensions.
Joseph Gillingwater
Head of international fixed income trading
Northern Trust
The large premium to borrow the current 10-year US treasury bond in repo markets and subsequent rise in failed trades, as noted by the Federal Reserve Bank of New York, has understandably received a lot of coverage. Meanwhile, the European Central Bank (ECB) maintains its presence as a large buyer of sovereign debt under its asset purchase programme, recently increasing the size and expanding the list of eligible assets to include corporate bonds.
Concurrently, regulation has forced banks to compete with the ECB and hold large inventories of high-quality debt rather than lend in the repo market, while institutions continue to shrink balance sheets and shift away from less lucrative and capital intensive business. However, we take comfort from the recognition of the issue from global central banks, while maintaining our position at the forefront of market evolution for initiatives to mitigate any liquidity risks.
Michael Landolfi
Securities finance product and strategy manager, markets group
BNY Mellon
The 鈥榬eality鈥� of the liquidity crisis is beholden to an individual鈥檚 definition of liquidity crisis. If one defines a liquidity crisis as a firm鈥檚 inability to obtain needed liquidity in a timely manner, then market evidence is indicating that currently no significant liquidity crisis exists.
If one defines a liquidity crisis as an environment where the liquidity resource has limits and constraints subjecting it to escalating prices and alternative sources, then evidentiary market data is indicating that a liquidity crisis may be developing with the implementation of regulatory reform and the reactive measures that financial institutions are adopting to comply with this new regulatory environment.
Financial institutions that recognise and innovate around this new emerging liquidity environment will be best positioned to succeed going forward versus their peers.
Karl Wyborn
Managing director, global head of sales
CloudMargin
Liquidity crises are not uncommon. We have witnessed several significant, acute reductions in liquidity in the periods during and after many of the crises that have peppered the last 20 years of financial market activity. These were neither structural nor chronic in nature, however. In contrast, what we witness today appears to be a structural reformation of the markets driven by new regulations. The marked decline in liquidity in US treasury repo over the last 24 months, during a period of otherwise buoyant economic growth, reinforces that the current challenges, while not yet endemic, are not simply an acute reaction to underlying economic weakness.
The real fear, however, is the impact of forthcoming regulations rather than what has passed before. The further implementation of Basel III, the migration to central clearing of over-the-counter derivatives and the exchange of initial margin on non-cleared derivatives will further reduce liquidity as banks, among others, hoard sovereign debt to meet their regulatory obligations. This is a widely anticipated and foreseen impact of regulators鈥� response to the global financial crisis. The 鈥榬eal鈥� question, therefore, is the extent to which regulators want to reduce liquidity.
James Treseler
Global head of cross-asset secured financing
Societe Generale Prime Services
We find that many institutions are struggling with applying the short- and medium-term liquidity ratios at a business line level.
But it is far from a crisis. However, it is worth noting that the industry, specifically the repo markets, have experienced exceptional squeezes on collateral. These events can be described as one-offs, not systematic at this stage.
Steve Baker
Director, securities finance
Markit
If we define liquidity risk in terms of funding, the risk of being unable to settle obligations with immediacy over a specific time horizon, we see several factors pushing in opposite directions and into cash market liquidity risks.
The repo market is the primary source of short-term funding for banks and an important short-term investment vehicle for money market funds and cash reinvestment for securities lenders. However, myriad regulations are forcing a retooling of its gears, disrupting market participants and liquidity flows until completed and digested鈥攁t least we hope.
Basel III鈥檚 risk capital and the more stringent US enhanced supplementary leverage ratio requirements have cumulatively encouraged banks to drastically modify their business models with regards to capital, assets and balance sheet. Banks have shed assets, particularly of the risk free lower yielding types such as repo, leading to reduced capacity to fulfil client requests to cover shorts (when not in inventory) and availability of high-quality liquidity assets (HQLA).
And while banks are required to secure longer term durable funding, Rule 2a-7 funds now have shorter weighted average maturity and higher stress testing requirements that have disrupted the historic symbiotic relationship between the two. To some degree, beneficial owners in the securities lending market are picking up the torch by accepting more alternative collateral types and longer cash reinvestment terms.
Our data has shown a significant and sudden rise in the use of evergreens since Q1 2016 within the US triparty market. In particular, with non-Fedwire eligible asset types such as equities and terms exceeding 30 days. This is encouraging and shows that banks are achieving greater operational efficiencies to term out funding and meet the new regulatory requirements. But what about those cash investors who seek short-term high quality collateralised investments and can no longer be serviced by banks?
Key questions remain open for the future of funding liquidity such as whether more of these traditional bank customers can join central clearing, or use peer-to-peer and direct repo and lending routes.
Nick Nicholls
Principal consultant
GFT
A liquidity crisis is very likely and is attributable to the impact of banking regulation on bond market demand. What holds this back today is that for the most part, we have quantitative easing in most large economies, with enforced low interest rates.
The impacts of capital regulations and leverage ratios mean that banks have less scope to hold higher yielding corporate assets. The result is that credit markets are constricted.
HQLA yields鈥攄riven down as a result of banks needing to hold reserves to meet liquidity ratios, and (from September) for initial margin on non-cleared derivatives鈥攁ren鈥檛 immune from a liquidity squeeze.
In a global economy where secondary market demand is constricted, a rate hike (as expected in the US) could see sellers without buyers of any size. The resulting fall in asset values will affect the HQLA reserves that banks are obligated to hold, leading to further loss of bank鈥檚 credit value.
Ted Leveroni
Chief commercial officer
DTCC-Euroclear GlobalCollateral
Once global derivatives regulations are fully implemented, there will be localised liquidity challenges鈥攅ither firm to firm or region to region. However, at a macro level, there is sufficient liquidity in the financial system. This disconnect between the macro and local level is due to the large number of collateral bottlenecks caused by limiting characteristics in financial market infrastructure.
These bottlenecks lead to eligible collateral becoming immobilised in one part of the system, making them unattainable for market participants that need access to their inventory of collateral for central clearing and higher margin requirements for bilateral transactions.
Eliminating this disconnect is key to avoiding a liquidity crisis and will require cross-border collaboration and the development of holistic, industry-wide solutions that allow firms to process and track their collateral, which will then facilitate centralised, automated collateral optimisation. Only then can the industry mitigate liquidity risk and solve the collateral challenge.
Scot Warren
Executive vice president of business development
OCC and the Options Industry Council
From OCC鈥檚 perspective as a central counterparty (CCP), we are seeing increased capital requirements affecting market behaviour. Due to their increased capital requirements, clearing firms are being more stringent with the credit they extend to liquidity providers and the balance they are allowed to hold. In turn, liquidity providers display less liquidity in the market. For other market participants, lower liquidity levels increase their implementation costs, therefore reducing the value of using CCP-cleared products. Diminished value for investors leads to lower demand for listed products.
Additionally, for CCP鈥檚 the cost of securing committed credit facilities is increasing and has become more challenging due to being included in single counterparty exposure limits. As a result, OCC is pioneering paths to finding new sources of liquidity by working with public pensions.
Joseph Gillingwater
Head of international fixed income trading
Northern Trust
The large premium to borrow the current 10-year US treasury bond in repo markets and subsequent rise in failed trades, as noted by the Federal Reserve Bank of New York, has understandably received a lot of coverage. Meanwhile, the European Central Bank (ECB) maintains its presence as a large buyer of sovereign debt under its asset purchase programme, recently increasing the size and expanding the list of eligible assets to include corporate bonds.
Concurrently, regulation has forced banks to compete with the ECB and hold large inventories of high-quality debt rather than lend in the repo market, while institutions continue to shrink balance sheets and shift away from less lucrative and capital intensive business. However, we take comfort from the recognition of the issue from global central banks, while maintaining our position at the forefront of market evolution for initiatives to mitigate any liquidity risks.
Michael Landolfi
Securities finance product and strategy manager, markets group
BNY Mellon
The 鈥榬eality鈥� of the liquidity crisis is beholden to an individual鈥檚 definition of liquidity crisis. If one defines a liquidity crisis as a firm鈥檚 inability to obtain needed liquidity in a timely manner, then market evidence is indicating that currently no significant liquidity crisis exists.
If one defines a liquidity crisis as an environment where the liquidity resource has limits and constraints subjecting it to escalating prices and alternative sources, then evidentiary market data is indicating that a liquidity crisis may be developing with the implementation of regulatory reform and the reactive measures that financial institutions are adopting to comply with this new regulatory environment.
Financial institutions that recognise and innovate around this new emerging liquidity environment will be best positioned to succeed going forward versus their peers.
Karl Wyborn
Managing director, global head of sales
CloudMargin
Liquidity crises are not uncommon. We have witnessed several significant, acute reductions in liquidity in the periods during and after many of the crises that have peppered the last 20 years of financial market activity. These were neither structural nor chronic in nature, however. In contrast, what we witness today appears to be a structural reformation of the markets driven by new regulations. The marked decline in liquidity in US treasury repo over the last 24 months, during a period of otherwise buoyant economic growth, reinforces that the current challenges, while not yet endemic, are not simply an acute reaction to underlying economic weakness.
The real fear, however, is the impact of forthcoming regulations rather than what has passed before. The further implementation of Basel III, the migration to central clearing of over-the-counter derivatives and the exchange of initial margin on non-cleared derivatives will further reduce liquidity as banks, among others, hoard sovereign debt to meet their regulatory obligations. This is a widely anticipated and foreseen impact of regulators鈥� response to the global financial crisis. The 鈥榬eal鈥� question, therefore, is the extent to which regulators want to reduce liquidity.
James Treseler
Global head of cross-asset secured financing
Societe Generale Prime Services
We find that many institutions are struggling with applying the short- and medium-term liquidity ratios at a business line level.
But it is far from a crisis. However, it is worth noting that the industry, specifically the repo markets, have experienced exceptional squeezes on collateral. These events can be described as one-offs, not systematic at this stage.
Steve Baker
Director, securities finance
Markit
If we define liquidity risk in terms of funding, the risk of being unable to settle obligations with immediacy over a specific time horizon, we see several factors pushing in opposite directions and into cash market liquidity risks.
The repo market is the primary source of short-term funding for banks and an important short-term investment vehicle for money market funds and cash reinvestment for securities lenders. However, myriad regulations are forcing a retooling of its gears, disrupting market participants and liquidity flows until completed and digested鈥攁t least we hope.
Basel III鈥檚 risk capital and the more stringent US enhanced supplementary leverage ratio requirements have cumulatively encouraged banks to drastically modify their business models with regards to capital, assets and balance sheet. Banks have shed assets, particularly of the risk free lower yielding types such as repo, leading to reduced capacity to fulfil client requests to cover shorts (when not in inventory) and availability of high-quality liquidity assets (HQLA).
And while banks are required to secure longer term durable funding, Rule 2a-7 funds now have shorter weighted average maturity and higher stress testing requirements that have disrupted the historic symbiotic relationship between the two. To some degree, beneficial owners in the securities lending market are picking up the torch by accepting more alternative collateral types and longer cash reinvestment terms.
Our data has shown a significant and sudden rise in the use of evergreens since Q1 2016 within the US triparty market. In particular, with non-Fedwire eligible asset types such as equities and terms exceeding 30 days. This is encouraging and shows that banks are achieving greater operational efficiencies to term out funding and meet the new regulatory requirements. But what about those cash investors who seek short-term high quality collateralised investments and can no longer be serviced by banks?
Key questions remain open for the future of funding liquidity such as whether more of these traditional bank customers can join central clearing, or use peer-to-peer and direct repo and lending routes.
Nick Nicholls
Principal consultant
GFT
A liquidity crisis is very likely and is attributable to the impact of banking regulation on bond market demand. What holds this back today is that for the most part, we have quantitative easing in most large economies, with enforced low interest rates.
The impacts of capital regulations and leverage ratios mean that banks have less scope to hold higher yielding corporate assets. The result is that credit markets are constricted.
HQLA yields鈥攄riven down as a result of banks needing to hold reserves to meet liquidity ratios, and (from September) for initial margin on non-cleared derivatives鈥攁ren鈥檛 immune from a liquidity squeeze.
In a global economy where secondary market demand is constricted, a rate hike (as expected in the US) could see sellers without buyers of any size. The resulting fall in asset values will affect the HQLA reserves that banks are obligated to hold, leading to further loss of bank鈥檚 credit value.
Ted Leveroni
Chief commercial officer
DTCC-Euroclear GlobalCollateral
Once global derivatives regulations are fully implemented, there will be localised liquidity challenges鈥攅ither firm to firm or region to region. However, at a macro level, there is sufficient liquidity in the financial system. This disconnect between the macro and local level is due to the large number of collateral bottlenecks caused by limiting characteristics in financial market infrastructure.
These bottlenecks lead to eligible collateral becoming immobilised in one part of the system, making them unattainable for market participants that need access to their inventory of collateral for central clearing and higher margin requirements for bilateral transactions.
Eliminating this disconnect is key to avoiding a liquidity crisis and will require cross-border collaboration and the development of holistic, industry-wide solutions that allow firms to process and track their collateral, which will then facilitate centralised, automated collateral optimisation. Only then can the industry mitigate liquidity risk and solve the collateral challenge.
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