BOE Is Looking Into Ways Collateral Demands May Disrupt Markets

The Bank of England is looking into ways in which financial stability can be undermined by demands that investors provide more security against derivative positions in moments of market turmoil.

The collapse of the U.S. insurer American International Group Inc. in 2008 showed how the sudden need to post billions of dollars of collateral prompted fire sales of assets, raising questions about the company’s creditworthiness and damaging confidence in the financial system, BOE Executive Director Alex Brazier said. That has prompted a shift away from over-the-counter trading of derivatives into clearinghouses, where positions are fully backed by collateral.


Alex Brazier

Source: Bank of England

“Greater reliance on collateral today means that although changes in counterparty credit quality are not met with collateral calls, market adjustments prompt much greater flows,” Brazier said in a speech in London on Thursday. “The avoidance of asset fire sales rests on those from whom the collateral is called having the means to meet the call.”

While there is now more than $1 trillion more collateral held against derivative bets than before the 2008 crisis and the amount is adjusted daily, those financial flows raise the question of whether participants would have to sell less-liquid assets to meet calls, Brazier said. Banks are required to hold buffers of liquid assets to cover 30 days of outflows, but that isn’t the case for other financial firms.

Insurance, Pensions

That’s led the BOE to focus its attention on insurance companies, pension funds and all the different types of investment funds, he said. For the moment there’s no question of regulation but rather a search for an answer to the question of how big a problem collateral calls might be, Brazier said.

To assess the risks, the BOE is developing “much better diagnostic tools,” he said.

The crisis-era run on money-market funds that eventually forced the U.S. government to step in to guarantee redemption at par showed what can happen if demands for repayment get ahead of the ability to supply it. The possibility of a “liquidity mismatch” developing is still real, even after funds have largely dropped promises of a certain redemption value, he said.

“Funds are increasingly invested in less-liquid assets while continuing to offer next-day redemption to investors,” Brazier said. He added that the share of corporate bonds held in open-ended funds in Europe has risen by 70 percent since the crisis.

“Their structure may create incentives for their investors to redeem in a stress, forcing fire sales of illiquid assets. I emphasise ‘may’ because we have not seen this on large scale in the past. Nevertheless, our duty is to ask whether we could see it in the future.”

The BOE is investing in the design of models that will help it to assess the risk of a major impact and the possibility that market participants’ separate reactions to a shock might amplify the effects, he said.

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