The new 40-page study, entitled “Collateral in Wholesale Financial Markets: Recent Trends, Risk Management and Market Dynamics,” tackles a topic that has been at the fore of discussion in the hedge fund industry since the $3 billion bailout of Long-Term Capital Management in 1998.
In the report, the BIS Committee on the Global Financial System suggests that a shortage of high-credit quality collateral may have a significant effect on the price dynamics of global markets.
“Scarcity of collateral could increase the cost of financial transactions, slow or inhibit financial activity and potentially encourage greater reliance on more inefficient non-price rationing mechanisms, such as restricting access to markets,” according to the BIS study.
The “shortage” itself is simply a byproduct of the rapid growth of global financial markets, which is enumerated in great detail in the study. Higher transaction volume worldwide is the culprit.
The risk profile of the available pool of collateral has itself shifted, complicating matters, according to the study. For instance, the proliferation of private sector-issued debt presents challenges because private issues tend to be smaller and less standardized in their features than those issued by governments.
“Additionally, there exist no liquid derivatives markets for private sector fixed-income securities. As a result, private issues are basically less liquid and more difficult to hedge than government securities, as indicated by larger bid-ask spreads and higher price volatility,” the study said.
Proper collateral management for prime brokers lending money to hedge funds may help mitigate risk, but liquidating the collateral will not cover the receiver’s full exposure to underlying transactions in the event of a fund default. What’s more, lenders must take into account that the value of the collateral itself will fluctuate over time. This means that it could be worth less at the time of crisis than when the collateral account was first established, the BIS paper suggests.
Correlation is an area risk managers need to pay special attention to, especially when it comes to less diversified hedge funds. Using a security for collateral for a hedge fund that in turn uses that same type of instrument within its fund strategy can be particularly risky.
“The use of securities closely related to the counterparty’s business as collateral can produce such a substantial correlation. This is the situation for some undiversified hedge funds that rely heavily on repo financing of their securities holdings,” the study said.
“In such circumstances, declining collateral values may intensify liquidity pressures when the fund’s creditworthiness is jeopardized by trading losses,” the BIS study went on to say.
In addition to presenting its new findings, the BIS study briefly revisits collateral-related issues during past stress periods in the markets-including the near collapse of Long-Term Capital Management in 1998, the failure of the Granite funds in 1994 and the stock market crash of 1987.
Christine Cumming, vice president and director of research at the Federal Reserve Bank of New York, headed the team that created the BIS report.
BIS is based in Basle, Switzerland. The international organization conducts economic research and fosters cooperation between central banks and international financial institutions.
By Pete Gallo, Editor PGallo@HedgeWorld.com