82nd International Atlantic Economic Conference

October 13 - 16, 2016 | Washington, USA

Role of collateral in supporting financial market liquidity

Friday, October 14, 2016: 2:55 PM
Joseph Noss, MPhil , Capital Markets, Bank of England, London, United Kingdom
Collateral plays an important role in supporting a vast range of transactions that help ensure the efficient functioning of the financial system. But it also has the potential to exacerbate risks to financial stability, not least given how – during periods of market stress – demand for high quality collateral may increase, whilst its effective supply may fall.

The paper estimates how this potential imbalance between collateral supply and demand is likely to vary as a function of market stress. To do so, a comprehensive framework is used to assemble and quantify the factors that affect the supply of and demand for high-quality collateral. Although the aggregate supply of such collateral is vast, only a small proportion of this is made available – via securities lending and repo transactions – to support market functioning.  Estimation is conducted of the degree to which this available supply of high-quality collateral is likely to decrease – and its demand increase – during periods of stress. This is due to a number of reasons, including the deterioration in market participants’ perceptions of their counterparties’ creditworthiness, and increases in the demand for collateral for use as an initial margin and in liquid asset buffers. We capture this variation in supply and demand by drawing together a number of observed empirical relationships between market participants’ behaviour in collateral markets and a combination of average dealer credit default swap premia (which we take as a proxy for perceptions of counterparty credit risk) and the VIX volatility index (which we take as a proxy for market stress and general economic conditions).

From the perspective of financial stability, the implications of an imbalance between the supply and demand of collateral by market participants are likely to be comparatively benign. The implications of a reduction in the willingness and/or ability of market participants to act as intermediaries in securities financing transactions, which are essential for the mobilisation of collateral, are likely to have more serious consequences for market functioning.

This work also provides a framework through which policymakers might be able to investigate how changes to the structure of collateral markets, as well as recently introduced prudential regulations, might affect the proximity of these risks.