In standard financial theory (and practice), presence of transactions costs has an impact on asset prices traded in the markets. A recent ECB Working Paper, titled "Collateral damage? micro-simulation of transaction cost shocks on the value of central bank collateral", by Rudolf Alvise Lennkh and Florian Walch (ECB Working Paper Series, No 1793 / May 2015: https://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1793.en.pdf) "analyses how changes in transaction costs may affect the value of assets that banks use to collateralise borrowings in monetary policy operations."
The authors estimate the effect of a 10 basis point increase in transaction costs to be a decline of -0.30% in collateral value. Adjusting for the expected drop in the volume of trades for each asset (reduced liquidity), the decline in asset prices is shallower - at -0.07%. "We conclude that banks will on average suffer small collateral losses while selected institutions could face a considerably larger collateral decrease."
So far - benign?
The problem, of course, is in that second order effect. The authors look at 25% and 75% decreases in turnover of pledged collateral debt instruments (e.g. bonds pledged by the banks in repo operations). This second order effect reduces the loss of collateral value to -0.22% and -0.07%, for the two assumed turnover reductions scenarios, respectively. In other words, the lower the turnover rate of the pledged assets, the lesser is the impact of the transactions costs on collateral value.
Now, as the study notes, when collateral is held longer (turnover lower), liquidity in the markets is impacted. The longer the banks hold collateral assets off the markets and in the central banks' repo vaults, the lesser is market liquidity for traded collateral-eligible paper. Thus, the higher is the associated liquidity risk. Banks dump risk premium into the markets.
Cautiously, the ECB paper goes on: "The results underline that transaction costs in financial markets can be one among many factors contributing to the scarcity or decline of liquid, high quality collateral. …an upward transaction cost shock that occurs simultaneously with a market or regulation-induced shortage in collateral assets, and in particular high-quality collateral assets, could hamper the access of financial institutions to central bank liquidity. The central bank could [make] additional collateral eligible for monetary policy operations. As most of high-grade collateral is already central bank eligible, such a move could entail a shift to collateral assets with more inherent risk that would have to be compensated with appropriate haircuts. This in turn could increase asset encumbrance on banks’ balance sheets."
But there is another channel not considered in the paper: reduced turnover of collateral implies reduced supply of assets into securitisation pools, as well as into the OTC markets. Both effects are hard to estimate, but are likely to induce even higher risk premium into the markets for risky assets, pushing the above estimates of costs wider.
As an interesting aside, the table below summarises, by the end of 1Q 2014, one quarter of all collateral pledged into Eurosystem central banks repo operations was of low quality variety Non-marketable assets (in other words, assets with no immediate markets). This represents an increase in the share of low quality assets from 24.75% in 1Q 2012 to 24.96% in 1Q 2014. Medium-to-low quality stuff accounted for another 20 percent of the total.
Now, for all the esoteric debates about the ECB supplying liquidity, not providing solvency supports, one wonders just how much of a haircut would all of this proverbial 'assetage' gather were it to be collateralised into the markets to raise the said liquidity… for you know: if a bank is solvent, its assets would cover its liabilities, inclusive of haircuts, which means they are repoable… in which case, of course, there is no liquidity shortage to cover, unless markets were misfiring. The latter simply can't be the case in 2014 when the financial markets were hardly oversold.