Collateral velocity is disappearing behind a digital curtain

Collateral velocity is a closely watched metric – with good reason. It is also becoming harder to measure accurately.

Tokenisation initiatives have the potential to exponentially increase the velocity – or reuse rate –  of pledged collateral. Digital money and collateral have near-instantaneous settlement timelines – one example being JP Morgan’s Kinexys Digital Assets platform, which allows users to exchange cash and collateral with settlement and maturity times specified to the minute.

This technology should be embraced and brought within the regulatory purview. But the current problem is that intraday digitally pledged collateral does not make it onto the balance sheet, or even into off-balance-sheet footnotes. JP Morgan’s investor relations team concede as much when asked about the bank’s latest quarterly reports. 

The bank states: “The methodology for the collateral metrics in our 10Q is based on a snapshot at the end of each business day. The nature of our repo trades on Kinexys is such that they typically open in the morning and close in the afternoon, resulting in an open balance for repos on Kinexys of zero at the end of any given day. As a result, intraday digitally pledged collateral that settles instantaneously would not be reflected in the end-of-day figures reported in our 10Q filing.”

And as the technology is more widely adopted, collateral velocity in global markets will become harder to measure and track.

Collateral velocity describes the reuse rate of securities in collateral chains. It is calculated by dividing the total pledged collateral received by banks by the amount of primary collateral sourced via reverse repos, securities borrowing, prime brokerage and uncleared derivatives activities. The resulting ratio measures the reuse of collateral posted by global banks that have a large footprint in this market.

A high collateral velocity can be a sign of excessive risk-taking and fragility in financial markets. But, properly managed, it can also reduce the need for central bank intervention. It has been encouraged in the past decade by central banks, including the European Central Bank and the Bank of Japan, which have made it easier for banks to lend collateral for cash and in many cases increased the central bank’s securities lending window.

Calculating collateral velocity is already tricky, however. Fortunately, collateral needs to be recorded on balance sheets – or footnotes to balance sheets – and the necessary data can therefore be found in the quarterly and annual reports of banks. For the past 17 years, I have collected this data by hand – artificial intelligence cannot do it – verifying it by cross-checking with investor relations at the top 20 banks and with hedge funds to calculate the velocity of collateral in global financial markets.

The data shows that collateral velocity declined sharply after the 2008 global financial crisis and remained depressed because of the European debt crisis and the prolonged quantitative easing policies of central banks, which restricted the availability of collateral.

In parallel, new regulations – Basel III and the Dodd-Frank Act – restricted dealer banks’ intermediation capacity, and global collateral reuse essentially became maxed out as a result (see table).

Since then, changes in the banking system have also led to greater concentration of collateral reuse. The exits of Lehman Brothers, Bear Stearns and, more recently, Credit Suisse, along with the reshuffling of business models at UBS and Deutsche Bank – all with a declining footprint in this market – have allowed JP Morgan and Barclays to gain significant market share in the past decade.

The latest data suggests JP Morgan and Barclays continue to lead the pack in this business, with each offering around $1.8 trillion in pledged collateral for reuse. US banks now account for over half the global $13 trillion market. Interestingly, the collateral velocity has remained near 2.0 for the past decade – despite the increase in pledged collateral that clients allow for onward repledging or reuse (see charts below).

Disappearing act

This type of analysis will be harder to perform in future, as pledged collateral information – and thus collateral velocity calculations or metrics – will be incomplete.

Banks are already piling into tokenised deposits. The float via intraday netting that accrues to large global banks – such as HSBC or Citi, Standard Chartered or JP Morgan – averages over $200 billion per bank. The float is clients’ free intraday money to banks, and this is changing.

Tokenised deposits also allow banks to leverage fractional banking, giving them an advantage over stablecoins, which must be backed 100% with high-quality collateral. While the market for stablecoins is projected to grow to $2 trillion–4 trillion by 2030, the potential for tokenised deposits could be even bigger.

But tokenised deposits are about instantaneous money (T+0), not collateral. To the extent that stablecoins can skirt dealer balance sheets by letting hedge funds connect directly with money market mutual funds – they currently need to interpose a rated broker-dealer – this will adversely affect the volumes in the pledged collateral market and/or aggressive pricing by banks in the pledged collateral business.

Furthermore, the emergence of bank-run technology platforms such as JP Morgan’s Kinexys means tokenised deposits can be seamlessly exchanged for stablecoins on an intraday basis, potentially increasing collateral velocity. This could improve the way the market is wired and reduce the need for central banks to intervene in repo markets.

In short, if regulations on dealer balance-sheet constraints are not relaxed, digital velocity may be the agent for change in rewiring global collateral. In the past decade, the alternate rewiring has been via large central bank footprint, such as the US Federal Reserve’s reverse repo programme in the trillions of dollars. Direct access to central banks’ balance sheets means money does not reach the dealer banks for intermediation; money and collateral do not get priced in one place, and this ‘rusts’ the market wiring.

The risk is that regulators could be blindsided by this much-needed rewiring of the global market if the regulatory reporting framework remains end-of-day.

Collateral is at an inflection point – and there are several ways it could go.

Manmohan Singh is the editor-in-chief of the Journal of Financial Market Infrastructures, and was with the International Monetary Fund for over 25 years. He is also author of Collateral markets and financial plumbing.

Editing by Louise Marshall