Collateral in wholesale financial markets: recent trends, risk management and market dynamics

Executive summary Purpose of study The use of collateral has become one of the most important and widespread risk mitigation techniques in wholesale financial markets. Financial institutions extensively employ collateral in lending, in securities trading and derivatives markets and in payment and settlement systems. Central banks generally require collateral in their credit operations. Over the last decade, the use of collateral in wholesale financial markets has grown rapidly. The collateral most commonly used and apparently preferred by market participants are instruments with inherently low credit and liquidity risks, namely government securities and cash. With the growth of collateral use so rapid, concern has been expressed that it could outstrip the growth of the effective supply of these preferred assets. Scarcity of collateral could increase the cost of financial transactions, slow or inhibit financial activity and potentially encourage greater reliance on more inefficient non-price rationing mechanisms, such as restricting access to markets. These developments suggest two questions for exploration. The first is to what extent trends in the use of collateral and its supply have created or have the potential to create a relative scarcity of low-risk, liquid collateral and, if such scarcity emerges, how markets could adjust. The second is how such adjustment mechanisms and other changes in collateral usage might alter market dynamics and the risk management demands on financial institutions, particularly in stress periods.