Tuesday, November 9, 2021
Since reading the Minutes of the Federal Open Market Committee July 27-28, 2021, I’ve wanted to learn more about the following statement: “Some participants cited various potential risks to financial stability including the risks associated with expanded use of crypotcurrencies or the risks associated with collateral liquidity at central counterparties [CCPs] during episodes of market stress.” (p.11) Today, I finally got my wish in reading about CCPs and collateral liquidity risks in the Federal Reserve’s recently released November 2021 Financial Stability Report (Report).
A box on p.51 of the Report entitled, Liquidity Vulnerabilities from Noncash Collateral at Central Counterparties, provides background on CCPs and collateral posting practices, noting that CCPs might need to monetize quickly noncash collateral in a time of extreme financial market stress. Were a CCP unable to do this, it could lead to a clearing member’s failure and further stress in markets. CCPs have liquidity requirements, which encompass cash and tools to monetize noncash collateral. The Report states: “The designated CCPs generally rely on three types of tools to monetize noncash collateral: (1) committed tools, such as committed lines of credit or committed foreign exchange swap facilities; (2) rules-based tools, for which the CCP rule book requires nondefaulting clearing members to provide liquidity support to the CCP; and (3) uncommitted or best-efforts tools, such as repurchase agreement (repo) transactions executed under an uncommitted master repo agreement or market transactions that may include sales of noncash collateral for same-day settlement.” (p.54)
“Designated CCPs” are CCPs that the Financial Stability Oversight Council has designated as “systemically important.” Under Dodd-Frank’s Title VIII, designated CCPs can have accounts and services at the Federal Reserve and, in certain circumstances, access to its discount window. I’ve written extensively about this (for example, here and here).
In July, the Federal Reserve established a standing repo facility. After reading the Report, I couldn’t help but wonder if the Federal Reserve will eventually designate some CCPs as counterparties to this new facility and, were this to happen, what the benefits and costs of such an arrangement would be? The Federal Reserve has stated that “Counterparties for this [standing repo] facility will include primary dealers and will be expanded over time to include additional depository institutions.” And, maybe eventually, CCPs?