Pricing and marginning liquidity risk September 22, 2012 at 8:53 am

Back in the mists of time, I heard about a trade whereby a Japanese fund paid an investment bank a (small) fee in exchange for the promise that they would make a quote on a large portfolio of illiquid equities if requested to do so. The bank didn’t promise to quote ‘at market’, just that they would quote. They could have quoted a single yen, but of course there would have been serious reputational implications to doing that, especially in Japan. So in effect the fund was paying for a liquidity risk backstop.

This came to mind when I read this post on a Sober Look about differences between bilateral and triparty repo haircuts during the crisis:

When a firm lent money to Lehman via repo on a bilateral basis, Lehman placed the collateral for this loan into the lender’s securities account – at Lehman. Once Lehman filed for bankruptcy, it would not pay back the money borrowed. The securities account where the collateral was sitting however was frozen by the court. By the time the lender was able to access her collateral and sell it, it had sometimes declined in value so much that the proceeds did not cover the loan balance.

On the other hand if the collateral was held by a third party such as State Street or BoNY, as soon as Lehman couldn’t pay, the lender was able to access and liquidate the collateral. Thus the differences in haircuts are not driven by the repo agreement itself… It’s driven by the fact that in a bilateral agreement it may take longer to access the collateral and liquidate it, potentially increasing losses. That risk of a longer liquidation period in the case of a default increased the bilateral haircut levels.

The difference between bilateral and triparty haircuts, in other words, represents a kind of liquidity risk premium. You could either deal with this in margin, or get paid a fee to take the risk in a bilateral repo that the triparty margin wasn’t adequate – as in the ‘pay for a quote trade’. You could even support the risk with capital. But in any case there is a risk there that needs to be understood, managed, and for which the risk taker requires a return.

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