Collateral management and secured lending are the big post-crisis themes in financial markets.
But what happens when a strategy that’s designed to protect the system backfires? Not because you don’t hold enough collateral to cover the counterparty risk, but — as it happens — because you’ve given too much of it away as haircut. If your counterparty suddenly turns out to be more fragile than you anticipated, you could find yourself with the equivalent of an unsecured exposure.
According to Richard Comotto, author of the International Capital Market Association’s bi-annual repo survey, it’s a notable and under-appreciated risk.
There are, after all, two sides to every trade.
Points he outlined to FT Alphaville on the sidelines of a European Repo Council seminar included:
- Investors are increasingly trying to protect themselves by demanding higher haircuts from counterparties, with the focus on the party receiving the collateral and offering the cash.
- This fails to account for the fact that there is still an exposure on the other side of the trade.
- What if the financier (sitting on the collateral) goes bankrupt? The over-collateralisation leaves the counterparty exposed on what is effectively an unsecured basis. They have volunteered collateral which is worth more than the loan, but may now never receive the assets back.
- The trend towards overcollateralisation will put more pressure on the collateral market which is already short of quality collateral.
- Some observers feel this will lead to re-evaluation of what is deemed acceptable collateral, and lead to more use of lower quality collateral… but possibly compensated for with ever higher haircuts.
- The haircuts charged by CCPs are much bigger than bilateral ones because their models demand more protection. This could eventually end up discouraging participants from using them.
We’d say this is an important consideration, especially for those institutions which depend on drawing liquidity from collateral markets. But also for anyone using CCPs, especially domestic ones, many of which are piling up on their wrong-way risk on account of the Eurozone crisis.
Related links:
Europe’s banks strike funding deals – FT
Clearinghouses and Wrong-Way Risk – Seeking Alpha