Sovereign wealth funds (SWFs) and central banks are emerging as large scale providers of collateral, providing a much needed boost in liquidity to the global financial system.
The finding comes from a joint study by Bank of New York Mellon (BNY Mellon) and the Official Monetary and Financial Institutions Forum (OMFIF), the London-based independent research and advisory group
Their report, entitled ‘Crossing the Collateral Rubicon: A new territory of challenge and opportunity for sovereign institutions’, notes the liquidity boost is coming at a welcome time when financial institutions face challenges from new regulations on risk mitigation and balance sheet management.
A total of 24 sovereign institutions with more than US$2 trillion in assets under management took part in the study. Thirty-seven per cent said they are in advanced stages of considering collateral trades or already implementing them and 66% reported that enquiries from potential counterparties in the trades were increasing.
“Collateral is becoming the sole determinant of institutions’ ability to engage in financial transactions in the cash or derivatives markets,” said Hani Kablawi, chief executive officer (CEO) of BNY Mellon’s asset servicing business in Europe, the Middle East and Africa (EMEA).
“Since the financial crisis, new regulations have placed a premium on counterparties gaining access to high-quality collateral. Yet central bank macroeconomic policies have reduced the supply of collateral. This has produced a great challenge for markets and a large-scale opportunity for official holders of these securities such as sovereign wealth funds.”
Quantitative easing (QE) programmes have resulted in central banks acquiring significant amounts of government securities, moving them away from traditional suppliers of liquidity such as banks and brokerage companies. These securities are among the most sought after for collateral trading. Governments that issue the highest-rated debt have had lower debt issuance in recent years, further constricting the supply, the report said.
“We now have a situation in which the lower-rated securities that cannot be used for collateral trading are circulating more freely than the higher-rated securities, which have been taken out of the markets,” added Kablawi.
“While the mismatch between demand and supply for credit is evident in the US and the UK, it has become particularly acute in continental Europe and has been a major factor behind the sluggish recovery. Sovereign institutions that provide collateral are playing an important part in overcoming these liquidity shortages and limiting market volatility.”
In turn, the falling oil price has helped to drive up demand for collateral from energy supplying nations.
One chief risk officer (CRO) for a Middle East sovereign fund that participated in the study said: “In the current environment of low oil prices, the liquidity framework becomes more important so investment activity can continue. We must make sure the liquidity profile is appropriate, prioritising liquidity over returns. In the future, maintaining the liquidity management framework is the key.”
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