Some new and compelling news stories over the last week spark up talk about shifting collateral needs, and more importantly, fundamental changes to bond market liquidity that we could impact securities finance in a profound way. Here is our take:
Bond market liquidity: Bloomberg’s Liz McCormick published an article, “Bond Anxiety in $1.6 Trillion Repo Market as Failures Soar,” talking about a foreshadowed loss of US Treasury market liquidity that is already showing up in repo failures. This is potentially serious stuff but we can’t agree that we’re seeing major anxiety just yet. The article’s argument is that “Now, more repo trades are going uncompleted, or failing, because it’s either too difficult or expensive for the borrower to obtain and deliver Treasuries. Such failures to deliver Treasuries have averaged $65.6 billion a week this year, reaching as much as $197.6 billion in the week ended June 18, Fed data show.” Ms. McCormick has been at the forefront of tracking losses in bond market liquidity following regulatory changes. For those interested, her well written article “Bonds Liquidity Threat Is Revealed in Derivatives Explosion” of June 16, 2014 is worth reading.
Germany collateralizes OTC derivatives to get better pricing: in another sign of the times, Bloomberg reported that Germany’s Federal Finance Agency will change some of its rate collateralization policies: “The Federal Finance Agency, which manages the Finance Ministry’s budget and short-term liquidity funding, plans to increase savings on the interest-rate swaps it currently uses by offering collateral on as much as 8 billion euros ($10.9 billion) of the trades as early as next year, agency spokesman Joerg Mueller said July 5 by phone. The agency may at the same time opt to use a central derivative clearing house in London and appoint a company such as Eurex Clearing AG to settle the transactions, he said.” This change settles some troubling questions we discussed in these pages in 2011 and 2012: why would sovereigns be exempted from posting collateral in financial markets for risk purposes? In fact, sovereigns not posting collateral was seen as part of UBS’s reason for getting out of the fixed income business.
Possible collateral savings of 20% in equity capital for banks: a study sponsored by Clearstream and written by consultancy Elton-Pickford, “Collateral optimisation – the value chain of collateral: Liquidity, cost and capital perspectives,” says that effective use of the “collateral value chain” can help banks save 20%, or EUR 40 billion, in equity capital. While part of the paper is a plug for Clearstream’s Liquidity Hub, there is also some interesting survey results here. One point we find telling is bank responses to the question, “What are the risks that you identified resulting from your involvement in a collateral ecosystem?” The answers are: Loss of operational independence: 40%; Gradual loss of an overall view: 40%; Systemic risk: 20%. We’ll be coming back to these topics soon in Finadium’s research report program and events.
Securities lending STILL adding value: a Wall Street Journal article, “Guggenheim Solar ETF Gets a Lift From Securities Lending,” echoes one of the findings from our asset management survey released yesterday: sure enough, securities lending still really adds value to fund managers. Who knew? Well, asset managers know, and that’s an important reason why they are keeping securities lending programs in place. As the article notes, “Over time, most index ETFs trail their benchmarks by a hair more than the fund’s expenses. Guggenheim Solar has annual expenses equal to 0.7% of assets. But over the past few years, the ETF has beaten the MAC Global Solar Energy Index by a median of 3.6 percentage points a year, according to research firm ETF.com.” That’s how it goes, and why funds that leave securities lending when their peers stay in produce worse returns over time.
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I am not sure the Bloomberg article makes sense. It in part blames the lack of available securities at the Fed for an increase in fails. By all indications, the problem is concentrated in on the run securities which the Fed rarely holds. In fact the Fed currently does not hold either the current 5 year note or the current 10 year note. So there is no divergence from the historical pattern of Fed holdings.
The 10 year note is explained b the Fed’s acution schedule. It generally trades most special between its initial auction and the first re-opening. (In this case May 15 to June 16.) In fact in the current environment the 10 year note is the one security that consistently has some value. What is interesting is that 2’s and 5’s also traded special. I would submit that this is more a function of bearish bets than lack of available securities.