Bloomberg News

Bond Buffer Seen in Demand for Swaps Collateral: Credit Markets

June 10, 2013

New collateral rules for hedge funds, insurers and others in the $633 trillion over-the-counter derivatives market are poised to boost demand for U.S. Treasuries, potentially slowing rising yields as the Federal Reserve considers scaling back unprecedented stimulus.

Swaps traders will need to come up with $800 billion to $4.6 trillion to meet Dodd-Frank Act regulations requiring that the derivatives be backed by clearinghouses that collect upfront collateral such as cash or Treasuries, according to estimates from the Treasury Borrowing Advisory Committee. The regulations take effect today for the second group of firms designated by the Commodity Futures Trading Commission in the market for interest-rate and credit-default swaps.

“This is going to be a new, very powerful engine that drives demand for Treasuries, so you have to expect it will impact yields,” said Ted Leveroni, executive director of derivatives strategy at New York-based trade-processer Omgeo LLC. “There are a lot of firms out there -- I know because they’ve told me -- that are concerned about having the available collateral.”

The rush for collateral may be an unintended benefit from swaps rules designed to protect against a cascade of bank failures.

Rising Yields

Mounting speculation that an improving economy will prompt Fed policy makers to taper $85 billion of monthly purchases of Treasuries and government-backed mortgage bonds triggered the biggest jump in 10-year Treasury yields since December 2010 last month. The yield reached 2.23 percent on May 29, the highest intraday level since April 2012.

The rise in the benchmark interest-rate helped fuel the biggest loss in U.S. investment-grade company bonds since the 2008 financial crisis, with the debt declining 2.28 percent in May on the Bank of America Merrill Lynch U.S. Corporate Index.

Clearinghouses seek to limit the effects of a user default by obtaining up-front margin and requiring additional collateral based on daily swings in market values.

Backing trades with collateral will transform a group of tightly interconnected banks and money managers into a more structured marketplace, CFTC chairman Gary Gensler said in an interview in New York last week.

‘Better System’

“It’s quite possible that there’s a tremendous amount of efficiencies when large financial institutions bring their swaps into one or two or three clearinghouses, rather than have these bilateral relationships,” he said. While “it has a cost,” he said, “it’s a far better system.”

Privately negotiated swaps complicated regulators’ efforts to resolve the 2008 financial crisis, which pushed Lehman Brothers Holdings Inc., one of the biggest dealers, into bankruptcy and prompted a government rescue of American International Group Inc., which had amassed bets on the U.S. housing market using credit derivatives.

The world’s largest swaps dealers including JPMorgan Chase & Co., Deutsche Bank AG and Barclays Plc, as well as active traders in the market, have been required by the CFTC to clear most of their trades since March 11. A third group of firms including pension plans will be phased into the clearing mandate in September. Only trades done after the effective dates must be cleared.

Treasury Anchor

“The demand-supply mismatch for high-quality debt is going to be an ongoing structural trend going forward that will help anchor short-term Treasuries,” Jerome Schneider, head of the short-term strategies and money-markets desk at Newport Beach, California-based Pacific Investment Management Co., said in a June 4 telephone interview. “Even if the Fed were to come in and adjust their monetary policy tomorrow, the short end of the Treasury yield curve will remain pinned.”

Demand for high-quality collateral to meet clearing mandates could reach $1.8 trillion to $4.6 trillion in “stressed” markets, according to industry estimates compiled by the Treasury Borrowing Advisory Committee, consisting of bond dealers and investors who meet quarterly with the Treasury Department.

Treasuries, government-backed mortgage bonds and some guaranteed asset-backed securities are among the types of debt instruments the committee said were deemed as “high quality.”

Global Regulation

Total demand stemming from additional collateral that will be needed to meet all new market regulations and global capital and liquidity rules for banks may reach $11.2 trillion, according to estimates by the committee in documents presented at its May meeting with Treasury officials.

“Yields are going down,” Nancy Davis, managing partner of Quadratic Capital and the former director of derivatives at AllianceBernstein Holding LP, said in a May 30 telephone interview. With automatic federal spending cuts this year, known as sequestration, and the potential for another congressional stalemate over the debt ceiling, “there has not been that much collateral being issued by the Treasury. And you are going to have huge collateral needs specifically for Treasuries.”

Rates for short-term government debt instruments, from bills to repurchase agreements, have already been falling this year even as long-term Treasury yields rise given a shortage of collateral.

Bill Shortage

After the government’s need for emergency cash in 2008 and 2009 pushed short-term Treasury bills outstanding to $2.1 trillion, the supply has since fallen to $1.7 trillion, or 14.1 percent of the government’s $11.4 trillion of marketable debt outstanding. That compares with a peak of 34.4 percent in December 2008. Securities maturing in three years or less have fallen to 49.5 percent this year from 60.2 percent in 2008, according to the Treasury.

The one-month Treasury bill rate dropped to negative 0.0051 percent on May 6, moving below zero for the first time since December. The rate was 0.0355 percent on June 7. The overnight Treasury repo rate, measured by the Depository Trust & Clearing Corp. general-collateral finance repo index, fell to 0.016 percent on May 29, the lowest since December 2011 and down from 0.29 percent at the end of 2012.

As the CFTC phase-in of the swaps rules has continued, CME Group Inc., the world’s largest futures market, has seen demand for its clearing service rise. While about 20 money managers began clearing trades at swaps clearinghouses around the world in March, Chicago-based CME had 118 firms clearing rates and credit swaps through its service in May, said Laurent Paulhac, senior managing director for financial and OTC products and services. About 540 firms have indicated they are interested in clearing trades with CME, he said.

Stocks, Gold

Other collateral that can be posted to back cleared swap trades includes stocks, corporate bonds and gold, all of which are given greater discounts, or haircuts, than Treasuries, diluting their value in a collateral arrangement.

Having a broader pool of assets available will alleviate pressure on the Treasury market, said Charley Cooper, head of clearing in North America for State Street Global Markets LLC.

“I don’t believe any clearinghouse believes the cash and government bonds model is the only one,” he said. “The old view that government debt stood head and shoulders above corporate debt is no longer held as conventional wisdom.”

Bond Discounts

At CME, corporate bonds used as collateral are discounted 20 percent, while equities face a 30 percent haircut. As the industry has prepared over the last three years for the clearing mandate, the fears of a collateral crunch have diminished somewhat, Cooper said.

“The general feeling is the collateral need, while significant, are less of a disaster than initially anticipated,” he said.

Swaps users won some relief last week with the U.S. Securities and Exchange Commission, which is regulating swaps tied to single securities, revising a measure that called for some to put up double the collateral dealers post for portfolio margin accounts at Atlanta-based IntercontinentalExchange Inc. The banks instead will be able to collect collateral from clients according to clearinghouse rules for six months.

Not every firm that must start clearing today is ready, either because they don’t have their systems connected to dealers and clearinghouses or because they don’t have legal documents in place, according to CME’s Paulhac, Cooper of State Street and Leveroni.

Banks Swamped

Leveroni said it can take six to 10 months to obtain legal documents to establish client-to-dealer clearing relationships and banks have been swamped with work. A majority of Omgeo’s derivatives clients fall into the category that must begin clearing swaps today, he said.

“I joke that for the first time there aren’t enough lawyers in New York,” he said.

Elsewhere in credit markets, Punch Taverns Plc, the owner of more than 4,000 U.K. pubs, changed the terms of its proposed 2.3 billion-pound ($3.6 billion) debt restructuring as it seeks to win support from bondholders. The cost to protect against losses on corporate bonds in the U.S. rose for the first time in three days.

The Markit CDX North American Investment Grade Index, a credit-default swaps benchmark used to hedge against losses or to speculate on creditworthiness, rose 1.7 basis points to 82.7 basis points at 11:50 a.m. in New York, according to prices compiled by Bloomberg.

Europe Swaps

In London, the Markit iTraxx Europe Index of 125 companies with investment-grade ratings climbed 3 to 107.1.

The indexes typically rise as investor confidence deteriorates and fall as it improves. Credit swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a swap protecting $10 million of debt.

The U.S. two-year interest-rate swap spread, a measure of debt market stress, fell 0.1 basis point to 18 basis points. The gauge typically narrows when investors favor assets such as corporate debt and widens when they seek the perceived safety of government securities.

Bonds of New York-based Goldman Sachs Group Inc. (GS:US) are the most actively traded dollar-denominated corporate securities by dealers today, accounting for 3.5 percent of the volume of dealer trades of $1 million or more, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

Punch Restructuring

Punch Taverns’ revised proposal includes faster repayments of its senior notes, limits on the amount of cash that can be removed from bonds securitizing income from the pubs, and an offer to buy back some higher-ranking securities, according to a statement from the company. The offer cuts Punch’s total debt service payments by more than 600 million pounds in the next five years.

Senior noteholders rejected an earlier deal because they said it didn’t address the business’s operational issues or provide a way for the debt to be refinanced or repaid. The Staffordshire, England-based company proposed a restructuring in February to delay repayments to one of its securitizations and cut the size of the other by 229 million pounds through a deal with junior bondholders.

To contact the reporters on this story: Matthew Leising in New York at mleising@bloomberg.net; Liz Capo McCormick in New York at emccormick7@bloomberg.net

To contact the editors responsible for this story: Alan Goldstein at agoldstein5@bloomberg.net; Dave Liedtka at dliedtka@bloomberg.net


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