To the extent that these markets and counterparties are important for the functioning of the financial system and for the real economy, problems transmitted can have adverse consequences for economic growth and financial stability. The market channel Let’s start with the market channel. Here excessive or poorly-managed leverage increases the potential for forced asset sales in the face of shocks, with adverse implications for market functioning and so the real economy. Feedback loops and amplification mechanisms can arise in two ways – through unexpected liquidity strains (most obviously as a result of margin increases) or through large, concentrated positions. I’ll cover liquidity strains first. Banks and CCPs typically require their counterparties to place collateral, in the form of margin or haircuts, to protect against counterparty risk. And sharp changes in asset prices, high volatility or correlated shocks affect the amount of counterparty risk to which they are exposed. As market prices change and as risk rises, the bank or CCP can request more collateral. (Variation margin to reflect the change in market prices; and higher initial margin to reflect greater risk in a given position.) And meeting those collateral demands creates liquidity risk for the leveraged institution that needs to be managed. This more widespread collateralisation of derivatives has been an essential part of the package of reforms to address fault-lines exposed in the Global Financial Crisis. Initial margin requirements are vital to limit cascading counterparty credit risks, as I will cover later.

But more widespread collateralisation has increased the sensitivity of liquid-asset demand to market volatility. And, if market participants are not prepared for such calls, their actions to raise cash can squeeze liquidity in already stressed markets, further amplifying shocks. So whilst greatly reducing counterparty credit risks, with important systemic benefits, collateralisation may also increase systemic liquidity risks. This dynamic was at play in the ‘dash for cash’ in March 2020, where hedge funds with highly leveraged positions in US Treasury cash-futures basis trades, were one source of the boost in demand for liquidity. [5] When markets turned against them, these investors unwound their positions, selling US Treasuries at scale, contributing to a short but extreme period of illiquidity in these usually safe and liquid markets. That added to dysfunction and necessitated unprecedented central bank intervention. [6] [7] [8] [9] The behaviour of financial intermediaries can also matter when a stress hits too - since what can seem rational behaviour for an individual firm has the potential to cause negative secondround effects when aggregated across the market as a whole. For example, low initial margins and haircuts in normal times can result in significant margin increases when a stress hits. If these occur market-wide, it can lead to a reduction in market activity, damage market functioning, and potentially amplify market moves at a time of stress. The second mechanism is via large, concentrated exposures, which can exacerbate the impact of liquidity strains and so amplify the impact of deleveraging on markets in the event of a shock.