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Market participants fear overlapping regulation for the banking and derivatives markets is helping to transfer risk into the more lightly regulated “shadow banking” market – the area the rules were supposed to rein in.
The issue may intensify next year as the new legislation begins to bite. OTC derivatives clearing has been mandated in the US while Europe is likely to announce its deadlines in coming months. “It’s somewhat problematic as these [clearing house] structures are fragile and can break in a crisis. The regulators didn’t really think about where the collateral is going to be coming from", says Craig Pirrong, finance professor at the University of Houston. “It’s going to be coming from the banking system and, crucially, the shadow banking system", he adds, referring to institutions like pension funds and hedge funds that do not have access to central bank money.
Estimates have varied wildly over how much collateral is needed. The Basel Committee overseeing global banking has suggested the financial system may need to find an extra $4 trillion. That amounts to more than a third of the high quality collateral in active circulation. However, it also argued the situation was manageable as eligible non-cash collateral for derivatives stood at some $50 trillion.
Central banks are keen, though, for the market to come up with its own solution to a potential collateral shortage, to reduce banks’ reliance on cheap central bank money. But market participants warn that attempts to turn to the private market for an answer are coming up against other regulations.
The Basell III regulatory capital rules, effective from January 2015, will get in the way of using the “repo” market for collateral management, banks warn. Repos, or sale and repurchase agreements, can be used to transform low quality collateral into assets acceptable to a clearing house.
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