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Collateral markets have become increasingly important as demand for collateral assets has increased in recent years, driven by changing market practices and an evolving regulatory landscape. In this environment, the design and implementation of central bank operating frameworks has gained importance for collateral markets, as central banks’ operational choices can affect these markets in a variety of ways, both intentionally and unintentionally, and vice versa. The potential effects of central bank operations on collateral markets are more important than ever, given the substantial footprint many central banks have left in markets for assets that also serve as collateral, following their large scale asset purchases and use of other unconventional policy tools over recent years.
Central bank operations are, in essence, asset swaps which alter the mix of assets available for use by private market participants. For example, a central bank that is providing liquidity to the financial system will typically either take collateral or purchase assets outright – so that, in either case, the central bank liquidity provided may be partly offset by a reduction in the stock of assets available for use as collateral in private transactions, such as repurchase agreements. Whether such effects on collateral markets are likely to be material depends on the size of these operations in relation to the markets for collateral assets and on whether financial market participants are constrained by the collateral available, as well as on a number of features of the financial system. Thus, these effects have the potential to become more important, due to any greater scarcity of collateral assets stemming from the global financial crisis and resulting regulatory changes.
Central banks have a number of design choices at their disposal that can influence markets for collateral – either through the supply of assets available for use as collateral, the pledgeability of various assets as collateral for private transactions, or both. In addition to the choice of monetary policy instrument and the operational parameters (scale, term, etc) of their transactions, these design choices include eligibility policy, haircuts and other terms and conditions, as well as counterparty access policy. In many cases, these choices are assigned to other objectives, notably central bank risk management; but they may be – and in some cases have been – used deliberately to support the functioning of collateral markets.
Examples include the loosening of eligibility criteria by the Eurosystem during the recent euro area sovereign debt crisis, as well as the various support programmes implemented by the US Federal Reserve to support collateral markets at the height of the financial crisis.
To examine this set of issues, the report first provides a broad conceptual framework for the analysis of such changes that distinguishes two main channels of impact: scarcity effects and structural effects. Drawing on a range of sources, including case studies as well as surveys and interviews with private market participants, it then examines the effects of different central bank choices on collateral markets. The report also suggests a number of metrics and other practical tools that might be useful as central banks assess how markets for collateral assets are influenced by their operational choices.
To help clarify the impact of central bank operations on collateral markets in conceptual terms, the report also distinguishes two different policy regimes: normal times versus times of stress. In normal times, when central banks tend to operate at the margin and on a limited scale, they typically set the features of their operating framework to be market-neutral. Beyond the intended effect on interest rates or asset prices, the impact of operations on collateral markets as such will thus tend to be small. Even so, central banks may of course decide to take targeted action to influence collateral markets even under such normal market conditions. Crisis times, on the other hand, are associated with greater scarcity of collateral in the financial system, as declining market confidence prompts a shift from unsecured to secured financing. Under such conditions, central banks may operate on a much larger scale, in some instances also inducing unintended side effects on collateral markets that have to be managed. Moreover, they are more likely to attempt to directly influence the functioning of collateral markets, for example by introducing facilities that allow banks to post illiquid collateral assets in place of liquid securities that, in turn, can be used to obtain funding in the private market.
In this light, the effects of central bank operations on collateral markets should be monitored carefully, particularly in connection with unconventional monetary policies and the eventual exit from those policies. Once central banks start to normalise their monetary policies, they will need to consider the implications for collateral markets of different tools available for use in that process.
The report also assesses the menu of available policy instruments that can influence collateral markets. Among other things, it suggests that, to prepare for any crisis response, some aspects of operational frameworks may need to be examined. This includes the adequacy of available inventories of collateral assets and of central banks’ risk management capabilities in stressed financial conditions.