PAY ATTENTION NOW, WE ARE VERY CLOSE TO DOOM: A Shortage of Bonds to Back Derivatives Bets
September 20th, 2012
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. American International Group (AIG) 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 (CME) 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.