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.

The crisis also emerged as a crisis of securitisation. Securitisation is an old and successful technique used to refinance a range of loans. What was new about it is that it got used extensively in highly unstable financial structures, which were financing short-term assets that were illiquid, complex, and whose value proved to be uncertain and contingent upon models. The instability of such structures was largely masked. Indeed, cheap money allowed easy refinancing of poor quality debt and of assets with uncertain value. Also, favourable ratings and credit enhancements artificially boosted the quality of loans underlying structured products. The rise in defaults on such loans, first on subprime mortgages, triggered a chain of reactions whose consequences are still unfolding now. Credit protections proved illusory. Liquidity dried up much more quickly than it had appeared. Rating agencies massively, suddenly and sharply downgraded products which until then were deemed of the highest quality. The demise of the “new” securitisation chain highlights two fundamental realities. The first one is that far from being spread across the whole system, credit risk was implicitly or explicitly concentrated in the hands of specific institutions, foremost among which were the major investment banks. Hence the successive waves of depreciations of structured products, imposed by the accounting rules in place, with these depreciations in turn fuelling doubts about counterparty risks and solvency, liquidity constraints and further falls in asset prices. The second reality is that recent financial innovation served mainly to increase leverage in the system. Signs of this are many.