:key bit:
“threat/credit event leads to volatility … leads to margin calls … leads to collateral hoarding/conserving …..leads to liquidity crisis …. leads to the next central bank intervention (only this time central bank balance sheets look worse than some of their banks).”
Longer form
Kathleen Tyson, markets guru, on X:
Okay, rewriting this in longer form.
Derivatives are contracts for differences where the liability between counterparties changes according to an underlying value (e.g., equity index, reference rates for foreign exchange or interest rates, etc.).
As the underlying value changes the derivative obligation changes too, often much more as derivatives can be highly leveraged. One side will be in the money and the other side out of the money almost all the time.
Regulations brought in post 2012 made margin on derivatives mandatory, so as the derivative obligation changes, margin has to move to cover any increase in the out of the money exposure or be released for any reduction by the in the money counterparty. For exchange traded derivatives (futures and options) the counterparty can be a clearinghouse or ‘central counterparty’.
They mark and make margin calls daily. Over the counter counterparties used to give each other a lot of slack as credit before a margin call issued, and tended to mark to market less frequently.
The aim of the mandatory margin regulation – as ever – was to increase ‘financial stability’ and reduce the impact of a counterparty default leaving the non-defaulting counterparty out of pocket. Most margin is provided in sovereign debt (e.g., US Treasuries, Bunds, Tresors, JGBs, etc.) so there was also a strong self-interest of supervisors in increasing the captive demand for ever increasing bond issuance by debtor states who control the Financial Stability Board (chaired by a deputy chair of the Fed at the time).
So as the value of a derivative claim shifts, the margin obligation shifts with it. Outsize volatility as we have had in interest rates since 2021, foreign exchange with dollar strength, etc. increases both the amount of margin that gets moved as collateral, and also the amount of eligible assets that must be reserved to cover any future volatility. Margin and collateral management are high cost and very complex.
Some counterparties will have stopped dealing in derivatives as no longer worth the bother. Where there is any hint of a crisis or outsize volatility it leads directly to illiquid interbank credit and repo markets as everyone suddenly needs to hoard collateral against margin calls.
This increases the impact of any threatening event systemwide. I’m not sure I’ve done a great job explaining what I meant, but basically threat/credit event leads to volatility leads to margin calls leads to collateral hoarding/conserving leads to liquidity crisis leads to the next central bank intervention (only this time central bank balance sheets look worse than some of their banks).
Qantitative Easing is a Permanent Growth Killer
