In a June 21, 2017 address before the 26th Annual Securities Finance and Collateral Management Conference in Berlin, Deutsche Bundesbank Board Member Professor Joachim Wuermeling warned that the securities finance sector faces some unique liquidity and collateral challenges. In particular, he noted that the extraordinary measures taken by central banks to shore up liquidity in the years since the financial crisis may be distorting liquidity and affecting collateral quality in securities lending and repo markets. Measures like the Public Sector Purchase Programme (PSPP) and central bank securities lending and bi-lateral repo facilities intended to backstop liquidity in securities financing markets may, in the long run, have unexpected effects on liquidity and could have a negative effects on transaction costs and order book depth, creating “fickle” conditions for market participants.
According to Professor Wuermeling, “today, we are facing a situation where central bank liquidity is hitting all-time highs daily while, at the same time, market liquidity appears to be fickle in a number of segments.” Securities finance appears to be one of these sectors. Some of this “fickleness” Wuermeling says is a result of PSPP activities and central bank securities lending and repo facilities. Securities purchased under the public sector purchase program (PSPP) have been made available for securities lending in a decentralized manner by Eurosystem central banks since April 2015. In addition, several Eurosystem central banks make their holdings under the three covered bond purchase programs (CBPP, CBPP2 and CBPP3) available for securities lending. While the effects of these central bank activities in the securities finance sector have not been studied thoroughly, a preliminary study suggests some unanticipated results:
"Academic evidence on the effects of non-standard measures is helpful for determining the need for remedial measures, but unfortunately rather rare. The Bundesbank and the Bank for International Settlements have launched a joint project which analyses the impact of purchases within the Public Sector Purchase Programme (PSPP) on prices and liquidity of Bunds in the first 18 months of the programme. The researchers provide evidence for negative side effects over the lifetime of the programme, e.g., decreasing Bund market liquidity. Based on data from the Bund cash market, the authors not only show deteriorating liquidity conditions over the course of the programme, but also find evidence that the purchases have a negative effect on transaction costs and order book depth. These findings suggest that the scarcity effects of asset purchases can impact adversely on market functioning."
Repo markets are also feeling liquidity strains as a result of central bank PSPP activities, Professor Wuermeling said. He noted that "especially at quarter or year ends we have seen deeply negative repo rates. This can be attributed to a variety of reasons, but the large-scale purchases of the Eurosystem may have played a role.”
At the same time, however, Wuermeling said that central bank repo facilities may also be helping to reduce overall volatility in the securities finance markets, at least in some sectors:
"In 2017, volatility in the repo market for German government securities has been rather moderate so far, even at the end of the first quarter. It seems that market participants have found a way to cope with the challenging environment. The Eurosystem's lending facilities may have contributed to this development."
Another criticism of central bank securities lending and repo facilities is their potential effect on collateral sufficiency and scarcity. Critics of central bank securities financing facilities have contended that "Eurosystem is accepting collateral of insufficient quality at excessively lenient terms.” This, in turn, they argue could create market distortions and large risks for the Eurosystem's balance sheet. Professor Wuermeling says that central banks have taken this concern to heart, however:
"The Eurosystem is taking this criticism seriously. However, it should be duly noted that, throughout the difficult times of the financial and sovereign debt crisis, the broad collateral framework was regarded as a great institutional strength of Eurosystem's monetary policy. While the pledged collateral has successfully protected the Eurosystem from financial losses, at the same time the collateral framework has been flexible enough to preserve the Eurosystem's ability to support market functioning and provide liquidity to the banking system in times of stress. The Eurosystem thereby fulfilled one of the core functions of a central bank.”
Professor Wuermeling acknowledged that increased regulation is another factor driving “fickleness” in liquidity and driving up the costs of capital to banks, noting that,
“. . .liquidity in the bond and repo markets has decreased, also - but not only - because of new regulations.”
'Moreover, the higher required capital ratios will increase banks' cost of capital while banks' earnings are currently compressed. This is making it difficult for banks to raise further capital, which is why they may respond to regulatory requirements by deleveraging. This, in turn, may well have negative effects on market liquidity.’
Wuermeling defended these regulatory changes as “effective and well-targeted,” and warned that “higher regulatory requirements will definitely stay.” Put bluntly, this new regulatory environment “is the ‘new normal’ market participants will have to adapt to."
The full text of Professor Wuermeling’s address is available via: http://www.bis.org/review/r170629f.htm