PUT TOGETHER ALL these aspects of financial innovation - experimentation, standardisation, infrastructure gaps and the illusion of safety - and one area of the post-crisis financial landscape flashes red as a potential source of problems: collateralisation, or giving a lender an asset as security in case a borrower defaults. Demand for collateral, at least in areas like OTC derivatives, is growing. In Europe in particular, bank creditors are pushing hard towards secured funding to protect themselves in the event of trouble. "A structural shift to collateralised funding is going on, and these forces are very strong," says Imène Rahmouni-Rousseau of the FSB. Moreover, perceptions of what counts as good collateral have changed. Before the crisis residential mortgage-backed securities of all kinds were being widely used in repo transactions (a form of short-term funding); now the emphasis is on finding highly rated government bonds, itself a shrinking universe. A recent IMF paper estimated that a decline in the amount of "pledged collateral," the sort that can be reused in other transactions, has reduced the overall availability of collateral by $4 trillion-5 trillion since pre-Lehman days (see chart 7). This collateral squeeze is fuelling all sorts of innovation. One which has already attracted the attention of regulators is the "liquidity swap," whereby holders of liquid assets, such as insurers and pension funds with government bonds, lend them to banks to use as collateral in their secured funding. In return, banks lend them less liquid assets and pay a fee. Such deals are not entirely new but there are concerns that they could quickly grow in scale, binding the insurance and banking sectors more closely together. Britain's Financial Services Authority issued some disapproving guidance about the practice last summer and has reportedly blocked a number of planned swaps since. If one path is blocked, bankers will try to find others. Christopher Georgiou of Ashurst, a law firm, says that banks are creating guaranteed repackaging structures in which assets are pledged as collateral and guaranteed by the bank. American regulators are also tracking attempts to launch a new type of funding instrument called "collateralised commercial paper," which some think has the potential to replace asset-backed commercial paper as a big source of financing. It works by giving investors a claim over collateral used in certain repo agreements without breaching new rules that prevent money-market funds from investing directly in such repo transactions themselves. The market has not yet caught fire, but supervisors are struck by how quickly the industry has started innovating in this area. "I am amazed that these things were developed before the rules were even in place," says one. Some banks see an opportunity to be collateral intermediaries. A clearing house may be wary of taking corporate bonds directly from a pension fund as collateral, say, but a bank can take the bonds and then issue its own letter of credit to the clearing house. In an echo of the triparty repo market, triparty collateral management is also becoming more popular. As Rajen Shah, head of collateral management at Citigroup, explains, under this system assets used as collateral sit with a third party. If brokers want to change the assets they pledge during the day, they can do so more quickly and cheaply via the agent than by managing collateral bilaterally. Within banks, too, collateral management has moved from the back of the back office to a much more prominent position. Institutions are investing in systems that provide them with a central view of what collateral is being held by different desks and allow them to move it around efficiently, to specify the order in which collateral is put to work during the day and to model the correlation risks embedded in different types of collateral (ie, if a counterparty defaults, whether its collateral is likely to sour, too). "Collateral departments were the orphaned, redheaded stepchildren of the organisation," says one executive. Now they are seen as the most interesting entrepreneurial and commercial opportunity. The market does a brilliant job of nurturing and refining instruments that people want. It is less good at planning for when things go wrong In many ways, the collateral craze exemplifies the challenges of judging financial innovation. The idea of using collateral to provide added security for the creditor is a sound one: it should reduce the riskiness of lending and the chances of a run. Such reasoning is reflected in the lower capital charges that banks incur for secured lending. Much can be done to improve the efficiency of collateral-management systems, and a rethink is needed on what counts as a safe asset. But the whirring of financiers" minds also spells trouble. As collateral flows more efficiently through the system and ways are found to transform and enhance it, the regulators have a big job to keep up. Working out which collateral belongs to whom, whether it is fairly valued, and what would happen at a systemic level if there was a big margin call on a particular asset class are all huge tasks for the future. There are also the familiar problems of interconnectedness and complacency. For unsecured creditors such as bondholders, the concern is a problem known as "encumbrance." It means that the more of a bank's balance-sheet is tied up as collateral, the fewer assets will be available to them in the event of a default. Again, data are in short supply. Fitch, a ratings agency, pointed out in December that European banks are both increasingly reliant on secured funding and reluctant to disclose which assets have been pledged as collateral. For secured creditors, the risk is that they will feel safer than they really are: valuation methodologies may not be right, for example, or assets may not be properly segregated. As in other areas of financial innovation, the best way of keeping the collateral problem under control is one of intrusive vigilance. That does not mean banning everything in sight. Finance has a very good record of solving big problems, from enabling people to realise the value of future income through products like mortgages to protecting borrowers from the risk of interest-rate fluctuations. It is tempting to choke off creativity in the aftermath of the crisis, but there is no obvious way of sifting the good innovations from the bad at the outset, and far less chance for the industry to mitigate problems - such as the impact of rising longevity, or inefficiency in public spending, or the lack of credit for millions of poor people in emerging markets - if it cannot experiment. The problems come along after the experimentation phase, when products have taken root and are growing wildly. The evidence of this special report suggests that the market does a brilliant job of nurturing and refining instruments that people want. It is less good at planning for when things go wrong. This is where regulators can play a benign role, signalling concerns early and loudly when activities reach a certain scale (as has happened with ETFs and liquidity swaps) and setting standards for data and reporting before the infrastructure starts to creak (as happened with CDSs in 2005). Regulators are far from perfect. They proved incapable of spotting danger before the crisis, and will doubtless make similar mistakes in the future. And finance will still have many old-fashioned ways to blow itself up. That is why it is so important to have lots of capital in the system to head off a calamity. But if innovation can be encouraged without being given licence to run riot, there will be a better chance of the industry doing good instead of harm.