It’s ironic, or it seems that way to us, that two of the least understood financial markets by equity investors are two of the most systemically important – repos and gold. Even more ironic is how so many investors don’t even consider them to be all that important. In our view, stability in both markets is a pre-requisite for maintaining confidence in the financial system and keeping the credit/asset bubble inflated. The significance of these markets is not lost on governments, central banks and regulators, although the definition of “stability” in each of them is slightly different. Looking underneath the bonnet/hood, we are doubtful that either of these markets, repos or gold, can reasonably be described as “stable” right now. There also seems to be a paradox where the current low repo rates and gold prices are, we suspect, fooling people into a false sense of complacency. What’s really piqued our interest, however, is whether there is a similar issue which is increasingly impacting both of these systemically important markets? This issue relates to the availability of sufficient collateral...
Via Paul Mylchreest's Thunder Road Report,
It’s ironic, or it seems that way to us, that two of the least understood financial markets by equity investors are two of the most systemically important – repos and gold. Even more ironic is how so many investors don’t even consider them to be all that important.
In our view, stability in both markets is a pre-requisite for maintaining confidence in the financial system and keeping the credit/asset bubble inflated. The significance of these markets is not lost on governments, central banks and regulators, although the definition of “stability” in each of them is slightly different.
The greatly under-reported repo market sits at the centre of the banking system and the securities markets. It is a primary source of leverage and, therefore, risk. Time after time, the risks remain hidden until events cascade beyond the point of no return. Stability in the repo market depends on confidence in repo counterparties (which can evaporate at near light speed, e.g. Lehman, Bear Stearns, MF Global and Long Term Capital Management), confidence in the valuation of collateral used in repo loans (remember subprime etc) and a sufficient pool of acceptable securities (e.g. Treasuries, MBS, etc) which can be pledged as collateral.
In stressed market conditions, liquidity crunches, declining collateral values and re-hypothecation (i.e. re-use of the same securities as collateral by more than one party) can undermine this market. This results in capital being wiped out, a run on collateral and the telltale sign of spikes in “fails-to-deliver”, when a scramble to post eligible securities ensues. Late 2008 was the example par excellence – here is what happened to fails-to-deliver in Treasuries (data is in US$m).
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When stress emerges in the financial system, the problem with the repo market is its tendency to be (very) “pro-cyclical” on the downside. It also operates pro-cyclically in terms of leverage and asset prices on the upside, which always seems to get forgotten.
Stability in the gold market for policymakers and regulators implies a stable gold price, preferably at “low” levels (i.e. well below all-time highs), an efficiently functioning gold futures market, ample liquidity in the gold lending (leasing) market and no heightened desire among gold buyers to take possession of physical
bullion. A surging gold price, backwardations and shortages of physical bullion are proverbial “canaries in the mine” regarding an overstretched system.
It’s belatedly dawning on more and more people that the price of gold on everybody’s Bloomberg screens is in fact a hybrid price of predominantly “paper” and “unallocated” (convention for LBMA settlement unless “allocation” specified) gold claims together with a much smaller pool (collateral) of physical gold.
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Looking underneath the bonnet/hood, we are doubtful that either of these markets, repos or gold, can reasonably be described as “stable” right now. There also seems to be a paradox where the current low repo rates and gold prices are, we suspect, fooling people into a false sense of complacency.
What’s really piqued our interest, however, is whether there is a similar issue which is increasingly impacting both of these systemically important markets?
This issue relates to the availability of sufficient collateral...
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