In a speech earlier this week, I put looming shortages of high-quality assets (HQAs) high on my list of growing systemic risks. Global central bankers fear it too, but the solution they’ve crafted is sadly a philosopher’s stone designed not to address the problem head-on, but rather to transform dross into gilt. The wizardry comes from “collateral transformation,” and a new report from the Bank for International Settlements on it shows all too clearly how desperately regulators are hoping that hocus-pocus transmutes whatever is lying around on the balance sheet into HQA. Want a new era of simple rules, transparent disclosures, and translucent risk? Hope on.
What is collateral transformation? Our client report, SYSTEMIC73, goes into this in detail and also spells out what the BIS’s Committee on Payment and Market Infrastructure (CPMI) says about it. In short, combined with the more traditional services of collateral optimization and management, it’s the business of helping financial institutions make the best use they can of all the HQAs they must get or give to meet an array of regulatory and market demands. Rehypothecation is a critical part of these services, but they increasingly involve transforming them into permissible HQAs so funds meet their requirements, traders can post eligible collateral to meet margin calls, banks can meet new liquidity requirements or hand over eligible collateral to a central bank, or a borrower can provide requisite backstops to a lender. In short, the money goes round and round, with transformation ensuring that rules are met, market demands are satisfied, and everyone – they hope – makes money along the way.
What could go wrong? The BIS report actually lays out a lot of the risks without suggesting anyone now do much about them. Opacity, operational risk, market illiquidity that worsens systemic risk – these are just a few of the issues the CPMI notes largely without comment. The earlier BIS report suggested that collateral transformation would be a cure to looming HQA shortages, perhaps the reason the new report treads so gently at a time these shortages are already threatening liquidity in the repo and corporate bond market – doing so well before the interest-rate hikes that scare me the most.
But, assume collateral transformation isn’t all that risky. Could it even work? A senior officer at a huge bank key to making it work told me earlier this week that this bank wouldn’t go anywhere near collateral transformation because it needs to hoard its own HQAs – a smart bank it is that knows better than to borrow trouble. Who then would lend the HQAs and hold the high-risk stuff? Big custody banks now make the market in collateral optimization and management. If they go into transformation in a big way, they’ll make a lot of money, but only at great risk possibly encouraged in a perverse way by the new enhanced supplementary leverage rules. Will hedge funds and asset managers see a new business? Right now, some like BlackRock are too busy trying to get banks out of the bond market to look also at this new business line. But, if there’s money there, you can count on them taking risk to serve market need and accelerate regulatory arbitrage.
The real cure to HQA shortages is not magic. It’s instead to look at the reasons markets are so desperate to transform assets into regulatory-eligible ones. Each of the rules that do so and all of the prudent market participants that also want HQAs are right. But, taken together, all of them could bring financial stability crashing down. Central banks and macroprudential regulations need to go back to basics and ensure that rules that require HQAs can be met with reasonable certainty without resort to complex, cross-border, and increasingly leveraged transactions. The bottom line of all these rules taken together is to demand that banks create HQAs out of thin air. A creative lot, they’re figuring out how to do so, but regulators should stop before the results of their handiwork – not the willing risk-taking of bankers – creates another brush with systemic calamity.