In the words of Goldman Doc, Morgan Grumpy, JP Happy, Bank of Sleepy, Barclays Bashful, Sneezy 
Citi, and Dopey Deutsche:
We dig dig dig dig dig dig dig from early morn till night
We dig dig dig dig dig dig dig up everything in sight
We dig up diamonds by the score
A thousand rubies, sometimes more
But we don’t know what we dig ‘em for
We dig dig dig a-dig dig
Collateral mining: one of the most overlooked and least understood bank funding sources in the financial system.
The concept stems from the latest IMF working paper, entitled ‘The non-bank-bank nexus and the shadow banking system‘, by Zoltan Pozsar and Manmohan Singh, in which they describe how asset managers have come to replace traditional creditors — primarily households — as the key financiers to the banking system.
Asset managers, from hedge funds and ETFs, to pension funds and insurance firms, have become the ‘ultimate sources of collateral’ for the so-called shadow banking system. Via the process of rehypothecation the practice leads to long complicated collateral chains and something the authors describe as ‘reverse maturity transformation’.
This is the process by which asset managers (especially real money asset managers), who are traditionally known to make long-term investment assets, voluntarily transform their long term assets into short-term liabilities (the sort that commercial banks would ordinarily create by taking in retail deposits).
The tendency to load up on short-term liabilities is due to a number of factors, but mostly managers’ desire to boost returns — something they can do by engaging in securities lending, a process which sees them receive cash collateral in exchange for the securities they loan. It’s a win-win situation, since the access to cash helps them manage the liquidity needs of their funds more easily.
But the asset management’s cash exposure has also gone on to influence the funding patterns of the financial system at large.
This is because asset managers generally want to reinvest the cash while they hold it. Their preferences are for non M2-type investments (that is, not investing in bank deposits) since their primary aim is to receive interest on the cash they hold as collateral, but to limit unsecured exposure to the banking system. As Pozsar and Singh note, no risk manager would sign off on significant unsecured bank exposures via uninsured deposits.
Since principal protection and interest are seen as key, this has tended to see the cash reinvested over extremely short durations in paper that’s as high-yielding and ‘safe’ as possible. Generally the preference is towards short-term publicly guaranteed debt such as Treasury bills and privately guaranteed wholesale funding instruments, such as repos. We’ve described it as the possible makings of an ‘overnight’ black swan.
As Pozsar and Singh explain:
The money demand aspect of the asset management complex is an often overlooked feature of modern finance. It involves massive volumes of reverse maturity transformation, whereby significant portions of long-term savings are transformed into short-term savings. It is due to portfolio allocation decisions, the peculiarities of modern portfolio management and the routine lending of securities for use as collateral. This reverse maturity transformation occurs in spite of the long-term investment horizon of the households whose funds are being managed. This reverse maturity transformation is the dominant source of marginal demand for money-type instruments in the financial system.
The flipside to the arrangement, of course, sees asset managers’ longer-term investments return to the system.
From the perspective of the dealer community, the hunt for collateral has actually become something akin to a goldmining operation, say the authors:
Banks (especially dealers) intermediate the collateral world to provide funding, settle trades, enhance returns for clients, and hedge counterparty risks on OTC derivatives. Obtaining collateral is similar to mining. It involves both exploration (looking for deposits of collateral) and extraction (the “unearthing” of passive securities so they can be re-used as collateral for various purposes in the shadow banking system).
The most valuable collateral being seen as the sort which can be re-used and re-pledged time and time again, a fact which leads to extremely long collateral chains, as illustraed here (click to enlarge):
Since it’s hard to track the linkages of this sort of reverse transformation and re-use of collateral, the authors say the process can have implications on our understanding of financial institutions’ balance sheets and the measurement of financial and monetary aggregates.
In other words, it can greatly obscure the picture.
Collateral crunches — or simply, a sudden lack of acceptable collateral in the system — can in this way also lead to much greater funding stresses than might otherwise be expected.
According to the authors, at the end of 2010 there was something like €5,800bn in off-balance sheet items of banks related to these sort of collateral mining operations and collateral re-use.
As they noted in the report:
While down from about $10 trillion at year end-2007, this remains very large, with micro-prudential and macro-prudential implications.
That makes the role of the central collateral desks, sometimes home to the banks’ ‘delta one’ operations, known for collateral ‘sweating’ strategies, one of the most important organs in a bank’s structure.
Most importantly, the desks link everything from demand for funding and collateral, to investment strategies and trading flows. It’s also why dysfunctions in repo markets can have such far reaching effects.
And why broker-dealers might end up invested in riskier than expected sovereign debt positions, with missing client funds to boot (potentially encumbered elsewhere).
The authors’ recommendations to regulators:
Regulators may need to reconsider and fine-tune the leverage definitions of banks to incorporate collateral chains due to the sizable volumes of pledged collateral that churn between banks and nonbanks. For example Lehman, at the eve of its bankruptcy (end- 2007), had $800 billion in pledged collateral that could be repledged in Lehman’s name, while its balance sheet size was only about $700 billion.
Quite.
Related links:
On the perils of plunging repo rates - FT Alphaville
It’s stock lending Jim, but not as you know it - FT Alphaville
The Non-Bank-Bank Nexus and the Shadow Banking System – IMF Working Paper