The collateral supply effect on central bank policy

Posted on February 22, 2021 by Florian Buschek

Carolyn Sissoko has recently given a presentation named after a paper of hers. There is also a video available. In it she argues that the nature of today’s funding markets, which are predominantly based on repo-lending, are incredibly fragile and the implications are neither well understood nor properly researched. One of the central themes is the role of collateral and how fluctuations in its value drain liquidity in moments of stress. If for example there is a fire sale of collateral then the collateral itself will devalue forcing further fire sales and so on.

Not only that but it is extremely sensitive to interest rates. Conventionally it is understood that rising rates make borrowing more expensive. But the impact is in fact exponentially higher because the collateral loses value. If for example a treasury bill trades at 101% of par (assuming 0% interest rates) and is used as collateral, then if rates rise to say 1% the bill will depreciate considerably depending on the duration. Let us assume it trades at 95 cents on the dollar, then all the sudden the borrower will have to put up additional collateral or if that is not possible because of capital constraints a fire sale ensues. The system is in other words prone to repo runs. March 2020 when suddenly rates spiked after they dropped to 0 was in some ways such an event and the Fed stepped in with all firepower it had and was forced to buy 5% of marketable Treasuries outstanding in 2 ½ weeks.

This is also the reason why it is incredibly hard to raise interest rates for central banks in developed countries.

On the flip side by lowering rates central banks not only lower borrowing costs (which investment works at 0% but not at 1%??) but most of all increase the value of collateral thus boosting lending capacity and thus liquidity.

This will clearly be very interesting to watch how it plays out over the coming years.

Abstract

This paper starts by describing the evolution of US money markets over the course of the 1990s and the 2000s. The crucial transition was from an unsecured core money market, the Federal Funds market, to a collateralized market, the repo market. Due to this shift, collateral supply has become an important factor in money market dynamics. Three important implications of this transformation are discussed: First, government debt issues now affect the money market not just due to the need to settle payment for the debt, but also due to the on-going need to fund the carry of the debt. Second, because long-term debt is an important component of collateral supply, any significant increase in long-term rates will have a dramatic effect on the value of the aggregate collateral supply thereby making monetary policy implementation more difficult. Third, the events of March 2020 provide evidence of structural instability in the repo market, and of the problematic nature of a ‘dealer of last resort’ solution. This paper argues that the collateral supply implications of the new money market environment merit careful study, and critically evaluates the dealer of last resort, the proposal for a centralized counterparty for Treasuries, and the proposal for a standing repo facility.

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