"We just keep piling on lots of operational risk as we convert one form of collateral into another."
"The dealers look after their own interests, and they won’t necessarily look after the systemic risks that are associated with this."
JPMorgan Chase and Bank of America are helping clients find an extra $2.6 trillion to back derivatives trades amid signs that a shortage of quality collateral will erode efforts to safeguard the financial system.
Starting next year, new rules designed to prevent another meltdown will force traders to post U.S. Treasury bonds or other top-rated holdings to guarantee more of their bets. The change takes effect as the $10.8 trillion market for Treasuries is already stretched thin by banks rebuilding balance sheets and investors seeking safety, leaving fewer bonds available to backstop the $648 trillion derivatives market.
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.” That’s raising concerns among investors, bank executives and academics that measures intended to avert risk are hiding it instead.
Adding to the concern is the reaction of central clearinghouses, which collect from losers on derivatives trades and pay off winners. Some have responded to the collateral shortage by lowering standards, with the Chicago Mercantile Exchange accepting bonds rated four levels above junk.
"We just keep piling on lots of operational risk as we convert one form of collateral into another. The dealers look after their own interests, and they won’t necessarily look after the systemic risks that are associated with this."
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Collateral Transformation: What You Need to Know
Sept. 11 (Bloomberg) -- Bob Rice, general managing partner with Tangent Capital Partners, explains Collateral Transformation.
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How to tell the difference between shit and shinola: