Pledged Collateral Market's Role in Transmission to Short-Term Market Rates

IMF Working Papers, May 17, 2019

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Short-term market rates in global financial centers are effectively determined in the pledged collateral market, where banks and other financial institutions exchange collateral (such as bonds and equities) for money.
Use of long-dated securities as collateral for short tenors—in securities-lending and repo markets, and prime brokerage funding—impacts risk premia (or moneyness) along the yield curve.
The paper deploys a methodology to show that transactions using long-dated collateral also affect short-term market rates.
The results suggest that the unwind of central bank balance sheets will likely strengthen monetary policy transmission, as dealer balance-sheet space is now relatively less constrained, with a rebound in collateral reuse.

Pledged collateral market as the effective locus of short-term rate determination.
Long-dated collateral rehypothecation and reuse influence short-tenor market rates via changes in collateral scarcity and moneyness.
Reuse of collateral by dealers alters the supply of high-quality collateral available for short-term funding, affecting overnight and short-term market rates.
The unwind of central bank balance sheets is expected to:
- Increase collateral reuse (rebound in collateral reuse).
- Reduce dealer balance-sheet constraints (dealer balance-sheet space is now relatively less constrained).
- Strengthen monetary policy transmission.

Central bank balance sheet normalization (unwind) has macrofinancial policy relevance by tightening the link between policy rates and short-term market rates through collateral-market channels.
Monitoring collateral velocity and reuse is important for assessing the strength of monetary policy transmission in financial centers.
Consideration of securities-lending, repo markets, and prime brokerage funding practices is necessary for understanding short-term rate dynamics and risk premia along the yield curve.

Subjects: Banking; Bonds; Central bank balance sheet; Central banks; Collateral; Financial institutions; Financial statements; Public financial management (PFM); Securities
Keywords: balance sheet; Bonds; central bank; Central bank balance sheet; central banks balance sheet; Collateral; collateral market; collateral velocity; excess reserves; Financial statements; Global; market; market rate; monetary policy transmission; overnight market rate; policy rate hike; rate; reverse repo; Securities; securities lender; securities lending; short-term market rate; transmission mechanism; utility value; WP