Risk may move from credit default swaps to repos

In the financial crisis of 2007-2008, much of the systemic risk that forced federal regulators to inject trillions of dollars into the financial markets to keep them from collapsing was caused by repos and credit default swaps.

Now it appears the swap risk may be transfered to repos, according to a July 11 story by Tracy Alloway in the Financial Times. The story is a valuable look at where the next repo-related dangers may develop.

Here’s how risk could be moved off of credit default swaps, which are a type of derivative, and onto the repurchase market:

The Dodd-Frank Act said many credit default swaps and other derivatives must begin trading through clearing houses, to bring more safety and transparency to a market that had largely been transacted privately between buyer and seller.

Large users of derivatives include banks, pension funds, mutual funds, hedge funds, insurance companies and corporations. A clearing house sets standards for a transaction and stands behind the transaction if one party defaults.

To protect themselves, clearing houses will require that derivatives users post bullet-proof collateral, such as cash or government bonds, to secure the derivatives transactions. From the Financial Times:

Morgan Stanley and Oliver Wyman estimate in a report that more than $2,000bn of additional collateral will be needed for over-the-counter (OTC) derivatives trades headed for central clearing in the coming years.

Many derivatives users don’t have enough cash or government bonds to support all their derivatives trades.  Where will they get it?

Some securities dealers, usually subsidiaries of big banks, are gearing up to offer collateral swaps to their customers who use derivatives. From the Financial Times:

These services are a first-draft attempt to give derivatives users access to the high-quality liquid assets that will be needed in a post-reform world trying to protect against the kind of turmoil seen in 2008. …

In a typical collateral swap, the securities dealer gives the derivatives user some government bonds, and the derivatives user gives the securities dealer some riskier bonds, like mortgage-backed securities, or some stock. In other words, the two parties swap collateral, with the derivatives user getting the bullet-proof variety, the government bonds.

The derivatives user can then give the government bonds to the clearing house to collateralize derivatives trades. Thus, the derivative appears to be secured with bullet-proof collateral.

But collateral swaps are usually structured as repos, and securities dealers admit they don’t eliminate risk. They just transfer it from the derivatives transaction to the repurchase transaction.

The risk will return to the derivatives user, and to the clearing house which thought it was protected by government bonds, if the repo lender – in this case, the securities dealer – gets uneasy and wants his government bonds back. From reporter Alloway:

Some banks planning to provide collateral transformation say they will not be able to provide unending liquidity to clients in the event repo markets falter.

Collateral swaps are an example of the type of innovation that was probably inevitable once the Dodd-Frank Act regulated derivatives and ignored repos.

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Related story: UK regulators warn of dangers in repo mutations