It’s chapter three of the latest Global Financial Stability Report, and it is especially good on the varying roles of safe assets in global financial stability, mispricing before the crisis and the decline in quantity since, and the tricky path ahead for reform.
— From the introduction, how’s this for a strong declarative opening…
In the future, there will be rising demand for safe assets, but fewer of them will be available, increasing the price for safety in global markets.
In principle, investors evaluate all assets based on their intrinsic characteristics. In the absence of market distortions, asset prices tend to reflect their underlying features, including safety.
However, factors external to asset markets—including the required use of specific assets in prudential regulations, collateralpractices, and central bank operations—may preclude markets from pricing assets efficiently, distorting the price of safety. Before the onset of the global financial crisis, regulations, macroeconomic policies, and market practices had encouraged the underpricing of safety.
Some safety features are more accurately reflected now, but upcoming regulatory and market reforms and central bank crisis management strategies, combined with continued uncertainty and a shrinking supply of assets considered safe, will increase the price of safety beyond what would be the case without such distortions.
— And on the different roles of these assets (we messed with the formatting to make it more readable):
The magnitude of the rise in the price of safety is highly uncertain given the broad-based roles of safe assets in global markets and regulations.
– Safe assets are used as a reliable store of value and aid capital preservation in portfolio construction.
– They are a key source of liquid, stable collateral in private and central bank repurchase (repo) agreements and in derivatives markets, acting as the “lubricant” or substitute of trust in financial transactions.
– As key components of prudential regulations, safe assets provide banks with a mechanism for enhancing their capital and liquidity buffers.
– As benchmarks, safe assets support the pricing of other riskier assets. Finally, safe assets have been a critical component of monetary policy operations.
These widely varying roles of safe assets and the differential price effects across markets make it difficult to gauge the overall price of safety.
There’s much more detail on each of these in the report itself.
— Here’s something interesting on the difference between US and European private repo markets, though note that it is limited to the Tri-party repo market and not the bigger, more opaque bilateral market:
In the United States, U.S. Treasury and agency securities—traditionally viewed as safe assets—collectively accounted for 83 percent of collateral in the U.S. tri-party repo market at end-September 2011. In Europe, sovereign debt accounted for 79 percent of EU-originated collateral in the repo market at end-2011. Tri-party repos account for only about 11 percent of repo transactions in Europe, where they relied on more diversified collateral, comprising government securities (45 percent),and another 41 percent in corporate bonds, covered bonds, and equity.
— And a note on how the move to central counterparties for over-the-counter derivatives will result in further encumbrance of collateral and less collateral velocity (rehypothecation):
The shift of a considerable number of OTC derivatives transactions to CCPs under proposed changes to OTC derivatives regulation will elevate collateral demand by between $100 billion and $200 billion for initial margin and guarantee funds, though some of this will offset current needs in the OTC market. The resulting lower ability to rehypothecate, or reuse, the collateral in additional repo contracts when it remains withina CCP’s default fund may intensify financial institutions’need for collateral to meet desired aggregate funding volumes. Indeed, one CCP has already decided that high-grade corporate bonds will be accepted as initial margin for swap trades as a resultof a shortage of high-quality assets.
— There are further thoughts in the note on quantitative easing that are somewhat obvious but probably don’t get made enough. One is that by lowering bond yields not just on sovereign debt but on other types of private debt, QE also improves the perceived safety of the latter. Another is that QE doesn’t really take safe assets out of the system; it merely swaps one kind of safe asset, sovereign debt, for another, reserves — the latter of which themselves also serve to ease liquidity strains in interbank lending markets.
— Lacking in the chapter is a deeper, explicit discussion of the money-like properties of safe debt as collateral and its implications for monetary policy — only the one mention above of rehypothecation, for instance, and then in the context of OTC derivatives regulation rather than repo markets. Also missing was the related discussion of how fiscal and monetary policy have become entwined precisely because of safe asset issues.
These aren’t huge omissions given the Singh and Sellas report on exactly these topics released earlier this morning (covered by Izzy and Joseph earlier), and which itself was released under the auspices of the IMF. And at some point it would further be great to have a European (or even global?) version of the work that James Sweeney did in the note we covered last week — ie a calculation of haircut-adjusted debt that could potentially be used as collateral in repo and secured lending markets.
— A summary of supply-demand imbalances in a single chart; note that all the demand factors will go either up or sideways:
— Here’s a more aesthetically pleasing, self-explanatory graph showing the kinds and holders of outstanding safe asset supply:
— And one more on the evolution of sovereign debt safety since the before the crisis:
— And on probably the single most important policy challenge for the developed world to get right (which it now isn’t, certainly not in Europe):
Both the lack of political will to reshape fiscal policies at times of rising concern over debt sustainability and an overly rapid reduction of fiscal deficits limit governments’ capacity to produce assets with low credit risk. When large primary deficits—in line with those observed in 2010—persist over extended periods, it is difficult to return public sector fundamentals to sound levels.
This suggests that unsustainable fiscal policies that are not reversed in a timely manner impair long-term asset safety. Conversely, up-front austerity measures could impair the sustainability of a country’s public debt, especially if accompanied by rapid private sector deleveraging and a contraction in GDP. Thus, the pace of improvement of fiscal fundamentals needs to account for the impact on economic growth and take into consideration country-specific circumstances.
Again click here for the whole chapter, where you’ll also find much more on Basel III, liquidity coverage ratios, and the future role of emerging markets in supplying privately produced assets (short version: their lack of financial infrastructure remains the key obstacle).
Our final takeaway is simply that this kind of attention for such a critical issue is most welcome, even if late, and it’s likely that the work of Sweeney/Singh/Poszar/Perry/Gorton/others will only increase in influence.
Floating Treasuries. Levitating Fed. – FT Alphaville
Money as maturity and asset transformation – FT Alphaville
When safe assets return – FT Alphaville
Why QE is being mis-sold – FT Alphaville