The opportunity cost of collateral pledged: derivatives market reform and bank lending

With the ongoing implementation of the over-the-counter (OTC) derivatives market reform, new reporting, clearing and margining requirements are being imposed on trading institutions. The cost of these requirements has been the subject of intense discussions, which have focused primarily on quantifying the absolute amount of collateral needed system-wide for trading institutions to comply with the new rules. While the paper briefly reviews this literature, it focuses instead on the opportunity cost of collateral pledged, which is the economically relevant cost from the vantage point of trading firms. Any additional unit of collateral pledged on derivative exposures would, absent the reform, have served an alternative purpose, e.g., debt financing in the repo market. The derivatives market reform has thus important consequences for banks’ financing and ability to lend. Furthermore, while absolute amounts of collateral demanded can be looked at system-wide, opportunity costs are meaningful only at the institution level, and depend on the marginal value of a unit of collateral for that institution. Because marginal collateral values are likely to be heterogeneous across institutions, the OTC derivatives market reform may have large distributional consequences for banks’ ability to hedge and lend. The substitution between perfect and imperfect, but less collateral-intensive, hedging is also discussed.