Issue #32: Collateral Transformation
In this issue of Monetary Mechanics, I am going to do a deep dive into a topic that I have already alluded to in previous issues of Monetary Mechanics: collateral transformation. Collateral transformation is an important issue, one that has become more and more relevant over the past decade, as various post-GFC legislations and regulations intended to safeguard the financial system have increased demands on the existing stock of high-quality liquid assets that are suitable as collateral.
Incremental Demand for High-Quality Collateral
Incremental Supply of High-Quality Collateral
What is Collateral Transformation?
The exact process of collateral transformation itself is relatively uninteresting. Collateral transformation is basically a collateral swap, whereby one counterparty swaps lower quality collateral with another counterparty who holds higher quality collateral. The exact terms of various collateral transformation trades vary from counterparty to counterparty and are usually bespoke. Compensation can come in the form of either (1) additional haircuts on lower quality collateral or (2) explicit fees.
The following scenario would constitute an example of a collateral transformation trade structured as (1) (additional haircuts on lower quality collateral): a hedge fund would like to enter into an OTC interest rate swap contract (either paying or receiving). This hedge fund does not have USTs on hand but does have BBB-rated corporate bonds on hand. First, the hedge fund enters into a deal with a securities broker who exchanges $110 worth of BBB-rated corporate bonds for $100 worth of USTs (sourced from a pension fund or some other type of “collateral silo”). Then, the hedge fund pledges the $100 worth of USTs to the central counterparty (CCP) in order to post initial margin (IM) to initiate its OTC interest rate swap position.
The following scenario would constitute an example of a collateral transformation trade structured as (2) (explicit fees): a hedge fund would like to enter into an OTC interest rate swap contract (as before) and holds the same BBB-rated corporate bonds (as before). However, the hedge fund, instead of pledging $110 worth of BBB-rated corporate bonds for $100 worth of USTs (via a 10% haircut), pledges the $100 worth of BBB-rated corporate bonds plus a fee that is negotiated individually. Aside from this difference, all other steps of the collateral transformation trade are the same.
These collateral transformation trades are often, but not always, structured as securities lending contracts, as these contracts offer the most flexibility and are also more favorable from a balance sheet standpoint (securities lending is often nettable while repo is not necessarily nettable). These collateral transformation trades benefit everyone: the hedge fund is now able to pledge collateral to engage in its swap position, the securities broker is now able to pick up a spread by connecting two counterparties, the pension fund or some other type of “collateral silo” is now able to earn excess returns on its USTs, and the central counterparty (CCP) is now able to remain within post-GFC legislative and regulatory boundaries.
However, even though they seem to benefit everyone in the private sector, these collateral transformation trades violate the spirit, if not the letter, of the post-GFC legislations and regulations that were enacted to prevent this exact type of risk. Post-GFC legislations and regulations mandated the pledging of high-quality collateral as initial margin (IM) in the opaque derivatives markets precisely because of the problems posed by contracts collateralized by less-than-pristine collateral, whose value could shift wildly in a short period of time. This was to ensure that anyone wishing to engage in these transactions should have a large stockpile of safe liquid assets that could be liquidated in the event of unexpected market volatility.
Historical Drivers of Collateral Transformation
Demand for collateral transformation began to heat up around 2013-2014 as many of the post-GFC legislations and regulations began to be put into place (particularly various provisions of Basel III).1 2 3 Demand for collateral transformation was particularly affected by the liquidity coverage ratio (LCR) requirement to hold high-quality liquid assets (HQLA) sufficient to cover a 30-day outflow of wholesale funding/financing, a requirement that froze up a significant portion of the C1 collateral base. Furthermore, the requirement that these high-quality liquid assets (HQLA) must be “unencumbered,” meaning that they could only be sourced through unsecured funding/financing (e.g. federal funds borrowings, certificates of deposit, etc.) also reduced circulation of eligible collateral and added additional burdens.
Impact of Basel III Requirements on High-Quality Collateral Supply
In addition to the first-order impact of requirements regarding the holding of high-quality liquid assets (HQLA), there was also the second-order impact of these requirements on large regulated financial institutions, which changed and adapted their behavior above and beyond what was officially required. These behavior changes and adaptations can be blamed for the repo spike in September 2019, as well as the UST repo problems in March 2020, which occurred during the COVID-related market crash.
While the liquidity coverage ratio (LCR) requirement reduced the effective supply of circulating high-quality collateral, it did not necessarily drive up the demand for collateral transformation trades. Instead, I believe that the demand for collateral transformation trades was primarily driven up by new initial margin (IM) and variable margin (VM) requirements on both standardized and bilateral derivatives transactions.
Impact of Derivative Clearing Requirements on High-Quality Collateral Demand
Impact of Bilateral Margin Requirements on High-Quality Collateral Demand
I believe that it was the impact of these new requirements on derivatives transactions that was primarily responsible for driving up the demand for collateral transformation trades, especially as requirements on bilateral derivatives transactions have been steadily increasing and are scheduled for final implementation by September 2022.
As Jeremy Stein stated in February 2013:
Collateral transformation is best explained with an example. Imagine an insurance company that wants to engage in a derivatives transaction. To do so, it is required to post collateral with a clearinghouse, and, because the clearinghouse has high standards, the collateral must be “pristine” – that is, it has to be in the form of Treasury securities. However, the insurance company doesn’t have any unencumbered Treasury securities available – all it has in unencumbered form are some junk bonds. Here is where the collateral swap comes in. The insurance company might approach a broker-dealer and engage in what is effectively a two-way repo transaction, whereby it gives the dealer its junk bonds as collateral, borrows the Treasury securities, and agrees to unwind the transaction at some point in the future. Now the insurance company can go ahead and pledge the borrowed Treasury securities as collateral for its derivatives trade.
Of course, the dealer may not have the spare Treasury securities on hand, and so, to obtain them, it may have to engage in the mirror-image transaction with a third party that does – say, a pension fund. Thus, the dealer would, in a second leg, use the junk bonds as collateral to borrow Treasury securities from the pension fund. And why would the pension fund see this transaction as beneficial? Tying back to the theme of reaching for yield, perhaps it is looking to goose its reported returns with the securities-lending income without changing the holdings it reports on its balance sheet.
There are two points worth noting about these transactions. First, they reproduce some of the same unwind risks that would exist had the clearinghouse lowered its own collateral standards in the first place. To see this point, observe that if the junk bonds fall in value, the insurance company will face a margin call on its collateral swap with the dealer. It will therefore have to scale back this swap, which in turn will force it to partially unwind its derivatives trade – just as would happen if it had posted the junk bonds directly to the clearinghouse. Second, the transaction creates additional counterparty exposures – the exposures between the insurance company and the dealer, and between the dealer and the pension fund.4
This specific problem has become more and more exacerbated since the GFC as the private sector struggled to source new C1 collateral and “transform” existing C2 collateral into new C1 collateral. Moreover, several market events have occurred over the past decade that have permanently impacted the “pristine” classifications of various classes of collateral that were previously perceived as risk-free (i.e. various classes of collateral were reclassified and moved from C1 to C2 as a consequence).
Impact of Collateral Transformation on the Financial System
Financial legislators and regulators perhaps never predicted the extent to which solutions would develop in the private sector, solutions that enabled the “renting” of high-quality collateral to satisfy these new requirements. The fact that these USTs are “rented” through these collateral transformation trades means that these OTC derivative contracts may appear to be collateralized by safe and liquid assets but are in actuality collateralized by much more risky and illiquid assets. Furthermore, this is limited only by the ability and willingness of securities dealers to engage in these collateral transformation trades. What this means is that the lower the quality of the collateral that securities dealers and “collateral silos” (e.g. pension funds, insurance firms, various other institutional investors, etc.) are able and willing to accept, the more implicit leverage risk-seeking investors can acquire through these collateral transformation trades.
Collateral transformation trades not only circumvent the original intended purposes of post-GFC legislations and regulations but also push this activity out of the spotlight of the more understood and policed parts of the financial market (e.g. repo) and into the shadows of the less understood and policed parts of the financial markets (e.g. bespoke securities lending contracts). Consequently, this created data gaps that caused financial legislators and regulators to be dangerously underprepared to anticipate and deal with financial issues and crises (e.g. MF Global, the European Sovereign Debt Crisis of 2011-2012, the Emerging Market Currencies Crisis of 2014-2016, etc.).
This behavior has kept UST yields depressed because institutional investors are buying USTs (and other high-quality sovereign bonds), despite their low and sometimes even negative real and nominal yields, not because of the investment income or capital gains from these securities, but because they can lend out these securities. Together, the ability and willingness of “collateral silos” to lend high-quality collateral to securities dealers and the ability and willingness of securities dealers to “transform” C2 collateral into C1 collateral via these collateral transformation trades govern the expansion and contraction of leverage in the global financial system. This occurs when “collateral silos” and securities dealers make it easier or harder to initiate or maintain OTC derivative positions. Consequently, I believe that these collateral transformation trades have become the marginal source of credit expansion and contraction in the global financial system, as well as being the largest and most important source of systemic risk.
https://www.bis.org/cpmi/publ/d119.pdf
https://www.atlantafed.org/cenfis/publications/notesfromthevault/1307
https://www.federalreserve.gov/newsevents/speech/stein20130207a.htm
https://www.federalreserve.gov/newsevents/speech/stein20130207a.htm