Markets Insight

February 5, 2013 2:45 pm

Crunch feared if collateral rules enforced

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New clearing regulations could suck in $10tn of safe assets

The law of unintended consequences rules in global financial markets. Attempts by regulators to stabilise one part simply create unforeseen problems elsewhere. Sometimes worryingly large holes are created – in the latest case, perhaps as large as $10tn.

European parliamentarians this week debated plans to make safer the financial derivatives industry – an essential cog in the global economy – where the notional amounts outstanding on over-the-counter deals exceed $600tn. Regulators want more trades processed through transparent exchanges and cleared through “central counterparties”, back office institutions that stand between two parties in a trade, ensuring they are completed even if one side defaults.

So far, so healthy. The problem is when trades are not sufficiently standardised to be cleared centrally. This might appear a technical question. But it matters a lot for the world beyond finance. Trades potentially affected include currency swaps used by multinational companies borrowing across foreign exchange markets.

Regulators are pushing for non-centrally cleared trades to be backed by high levels of collateral, such as cash or government bonds. This is where the $10tn figure comes in. It is the amount of extra collateral that could be required according to estimates by the International Swaps and Derivatives Association.

Admittedly the $10tn figure is based on fairly extreme assumptions about what exactly the rules would require. Still, even if lower, the volume of safe assets that would be sucked out of use by the financial system would be massive. While central banks were trying to stimulate economies using “quantitative easing”, the world’s regulators would be undermining their efforts with rules that, in effect, restrict credit supply and thus economic activity. Worried about the lack of joined up thinking, the European parliament’s economic affairs committee voted late on Monday to delay implementation of the new plans in Europe.

Of course, in a big and complex industry like financial derivatives it is easy to create scare stories. Regulators would point to the scope for minimising collateral demands, and argue a safer financial system is better for the economy. But the disputes over derivatives trading highlight how poorly understood are the interactions between financial regulation and other policy levers used to steer the economy, especially by central banks.

Before the financial crisis, central banks set interest rates with the aim of ensuring stable growth and prices. Regulators targeted bank-level threats to financial stability. The past few years have shown roles cannot be split so easily. Post-crisis, “macro-prudential” regulators are taking a more holistic approach, looking at general threats to financial stability. But as a paper on the subject published this week by the International Monetary Fund admits, “experience and knowledge on the effectiveness of macro-prudential policies ... and interactions of those tools with monetary policy ones are still limited”.

The idea behind macro-prudential regulation is that it can somehow make up for weaknesses in monetary policy, for instance by preventing dangerous asset price bubbles. In fact, as the debate over derivatives regulation illustrates, the problems at times of weak economic growth can sometimes be the opposite: regulatory policies can undermine the effectiveness of monetary policy.

What the arguments over derivatives regulations also show is the unintended consequences of policymakers’ actions on collateral supplies, which are vital for the safe functioning of the financial system. A separate IMF paper published last week by Manmohan Singh, who has carved himself a role as a collateral expert, argues regulators are also throwing spanners into the financial system by restricting the multiple, or re-use of safe assets as collateral, which has helped finance flows in the past.

Mr Singh puts the total additional collateral requirements resulting from regulatory changes at between $2tn and $4tn – less than the $10tn figure cited by the ISDA derivatives lobby, but still the same order of size, for instance, as the European Central Bank’s balance sheet.

But central banks are also, inadvertently, restricting collateral supplies. Mr Singh points out that bond purchases by the Swiss National Bank to prevent its currency’s appreciation “withdraw the best and most liquid collateral from the [neighbouring] eurozone”. Similarly, Fed purchases of US Treasuries and mortgage backed securities “could silo over $1tn additional good collateral in 2013”.

The risk is of a “collateral crunch” at some point. The law of unintended consequences seems pretty universal. The real economy pays the price.

Ralph Atkins is the FT’s Capital Markets Editor

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