Author : John E. Charalambakis
Date : February 23, 2016
In our commentary dated February 10th (http://stage.blacksummitfg.com/3375) we outlined the significance of collateral velocity and the inherent dangers of another crisis given that the main culprit (derivatives) of the 2008 crisis has not been addressed yet. The opaque process of collateral chains faces significant credit bottlenecks that are clogging the financial system’s arteries. The result has been market volatility and rising risks. Like a corporation whose loan become non-performing, a transformation and restructuring is required. In the case of a corporation, a CRO (Chief Restructuring Officer) may institute a collateral workout mechanism that will satisfy the creditors and advance the corporation’s chances for stability and growth. In a similar manner, the financial system needs a collateral transformation in order for the system to survive and the economies to experience a normalized growth path.
We reiterate that we reject the secular stagnation theories, because there is nothing secular about stagnation. As of this writing, news came in that the London Stock Exchange Group is in merger talks with Deutsche Borse in order to create a new institution that will manage derivatives. We are of the opinion that this kind of move reflects the concerns that a shortage of collateral is on the rise. If that is true, then market tremors will intensify dollar shortages across the globe which in turn will suppress even further the velocity of collateral.
Our fear is that the collateral shortage increases counterparty risks (bilateral, among clients and prime brokers, as well as among clearing houses). The higher counterparty risks in turn create problems in the aggregation and allocation of collateral to meet various financial exposures. Hence there is a mismatch between demand and supply of collateral. The new regulatory framework has increased the demand for collateral (e.g. by requiring that all OTC derivatives transaction be settled through clearing houses) by such a significant amount that it has created collateral bottlenecks to the tune of 15% of all available collateral. As a result, the inability to view and utilize all available collateral exacerbates financial inefficiencies and as the industry leader (DTCC) has stated, such an inability “could exacerbate collateral shortfalls, particularly as a prelude to or during a financial crisis.”
Furthermore, margin call requirements related to collateral are rising by as much as 500-1000%. The consequence of that is liquidity issues worsen, and risks rise. One of those “unseen” risks is the fragmentation between bank and nonbank (hedge funds, pension funds, insurers, etc.) balance sheets, which has the potential of reducing the size of the repo market. As the latter shrinks, the velocity of collateral is reduced too, leaving the financial system with more liabilities than assets, and therefore susceptible to a financial crisis. Furthermore, as financial lubrication is reduced not only is the amount of available collateral decreasing but the collateral chain also shrinks. The shrinkage of the latter reduces credit creation further and generates more fears into the market.
When fears translate into a deficit of trust among market makers then the financial instability hypothesis becomes a reality that starts demanding payment on the notional amount of the liabilities represented by the derivatives superstructure.
The musical chairs in their full glory…