A Shortage of Bonds to Back Derivatives Bets

Banks offer to swap Treasuries for riskier bonds to fill the gap | “We just keep piling on lots of operational risk”

Bradley Keoun


Starting next year, new rules will force banks, hedge funds, and other traders to back up more of their bets in the $648 trillion derivatives market by posting collateral. While the rules are designed to prevent another financial meltdown, a shortage of Treasury bonds and other top-rated debt to use as collateral may undermine the effort to make the system safer.

Derivatives allow buyers to bet on the direction of currencies, interest rates, and markets, insure against defaults on bonds, or lock in a price on commodities. The new rules are rooted in the 2010 Dodd-Frank Act, passed in reaction to the near-collapse of the financial system in 2008, which was caused in part because derivatives contracts weren’t backed by enough collateral (page 60). American International Group needed a $182.3 billion bailout from the U.S. government after it failed to make good on derivatives trades with some of the world’s largest banks. In response, Congress required that most privately negotiated derivatives transactions, known as over-the-counter trades, go through clearinghouses.

Clearinghouses, run by firms such as Chicago-based CME Group and London-based LCH.Clearnet Group, make traders provide collateral, including government bonds, that can be seized and easily converted into cash to cover defaults. Traders may need from $2 trillion to $4 trillion in extra collateral to meet the new requirements, according to Timothy Keaney, chief executive officer of BNY Mellon Asset Servicing.

The trouble is finding all that high-grade debt. The U.S. had $10.8 trillion in Treasuries outstanding at the end of August. Other countries, including Japan and European nations rated AAA or AA, had about $24 trillion of debt in the second quarter of 2011, according to an April report by the International Monetary Fund. Those government securities are already in heavy demand from central banks and investors.

The solution: At least seven banks plan to let customers swap lower-rated securities that don’t meet standards, in return for a loan of Treasuries or similar holdings that do qualify, a process dubbed “collateral transformation.” The maneuver allows investors who don’t have assets that meet a clearinghouse’s standards to pledge corporate bonds or mortgage-linked securities to a bank in exchange for a loan of Treasuries. The investor then posts the Treasuries — the transformed collateral — to the clearing-house. The bank earns fees plus interest, and the investor is obliged at some point to return the Treasuries. In effect, the collateral is being rented.

That’s raising concerns among investors, bank executives, and academics that measures intended to avert risk are hiding it instead. “We just keep piling on lots of operational risk as we convert one form of collateral into another,” says Richard Prager, global head of trading at BlackRock, the world’s largest asset manager.

JPMorgan Chase and Bank of America are already marketing their new collateral-transformation desks, executives at the companies say. Other banks confirmed they’re planning to offer the service too, including Bank of New York Mellon, Barclays, Deutsche Bank, and State Street. “Collateral transformation is a client service that does not hide risk,” says Jennifer Zuccarelli, a spokeswoman for JPMorgan Chase. “It is a form of short-term secured lending, which has always been an important part of capital markets, subject to tight capital and liquidity rules and fully transparent to regulators.” Goldman Sachs Group also plans to offer collateral transformation, a person with knowledge of the matter said. A spokeswoman for the bank declined to comment.

For the banks, an expanded securities-lending market could generate billions of dollars in fees, even as the industry faces shrinking profits due to regulations that increase price reporting and competition in derivatives trading, according to a report from consulting firm Oliver Wyman Group. At the same time, they could suffer losses if a trader defaults and his collateral is seized. In that case, the bank loses its Treasuries and is left holding lower-grade bonds that the trader posted in the collateral transformation. The banks’ new lending business “smells like trouble,” says Anat Admati, a finance and economics professor at Stanford Graduate School of Business who studies markets and trading and advises bank regulators on systemically important firms. “The point of the initiatives on derivatives was that derivatives can hide a lot of risk,” Admati says. “Now they’re going to just shuffle the risk around.”

The bottom line Rules requiring traders to post more collateral in the $648 trillion derivatives market could lead to risky securities-lending deals.


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