The role of collateral in supporting liquidity

ABSTRACT Collateral plays an important role in supporting a vast range of transactions that;help ensure the efficient functioning of the financial system. But collateral markets;also have the potential to exacerbate risks to financial stability, not least given that,;during periods of market stress, demand for high-quality collateral may increase,;while collateral availability may fall. This paper offers a means to estimate how;this potential imbalance between collateral supply and demand is likely to vary as a;function of market stress. In addition, it offers an estimate of the increase in market;volatility sufficient to cause a dislocation in the market for collateral and a subsequent;deterioration in market functioning. It suggests that, from the perspective of financial;stability, the implications of an imbalance between the supply and demand of collateral;are likely to be comparatively benign, but that a reduction in the willingness and/or;ability of market participants to act as intermediaries in collateral markets is likely to;have more serious consequences for market functioning. This work also provides a;framework through which policy makers can investigate how regulations might affect;the proximity of these risks.