EU banks forced to up collateral for ETDs in Q4 2020

Over-collateralisation of European Union banks’ exchange-traded derivatives (ETD) liabilities at end-2020 was the highest since the previous March, European Banking Authority (EBA) data shows – a sign of how margin requirements can ramp up despite ostensibly benign market conditions.

As of the end of last year, security posted by lenders in ETD transactions was 23.3% in excess of their liability, compared with 12% at end-September and 17.4% at end-June.

 

 

It was the highest level of over-collateralisation for ETDs since March 2020, when a pandemic-induced flurry of margin calls pushed collateral requirements 44.2% above liabilities, surpassing March 2018’s 34.9% high.

Collateral requirements for over-the-counter derivatives, in contrast, remained below liabilities, though the gap receded from 6.8% at end-September to 5.7% at end-December. In March 2020, it temporarily shrank to just 1.9%.

Overall, EU banks’ liabilities were collateralised for 13.2% of their value at end-2020, in line with six and 12 months prior.

What is it?

The EBA publishes a report on EU banks’ asset encumbrance every six months.

The over-collateralisation level is defined as the assets and collateral that institutions have to pledge relative to the matching liabilities. 

Why it matters

The EBA warns that having too much of a bank’s balance sheet already tied up as collateral may cause concern around its ability to raise liquidity as needed – e.g. through repos – and raise its cost of funding. “This could lead to an adverse feedback loop of higher encumbrance, higher funding costs and diminishing liquidity,” the agency wrote in its report.

That said, rising collateralisation requirements for ETDs are unlikely, on their own, to cause a liquidity crunch for EU banks. Even as margin requirements gaped in March of last year, ETD liabilities sucked up just 1.3% of banks’ assets. Compare that with central bank funding, which tied up 24.2% of lenders’ assets at end-2020, more than twice the proportion as a year prior.

Nevertheless, the sudden rise in excess collateral for ETD liabilities – and shrinking under-collateralisation for OTCs – arguably shows how quickly derivatives can lock up swathes of a firm’s balance sheet, even in apparently tranquil markets.

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