Treasuries Face Harsher Collateral Treatment - Does This Make Sense?

By Larry Tabb, TABB Group

Originally published on TABB Forum 

Forcing clearinghouses to back up their US Treasury positions with letters of credit backed by US financial institutions in US dollars seems silly. 

I just posted a story to the FORUM news feed from Matt Leising at Bloomberg titled, “Treasuries Face Stiffer Treatment as Collateral Amid Overhaul.” According to the article, industry executives report that “rules being considered by federal regulators (CFTC) could require clearinghouses to back up Treasuries pledged as collateral in the $693 trillion over-the-counter derivatives market with credit lines.”

Am I the only one that thinks this is a bit silly?

I don’t disagree that clearinghouses are the next “too big to fail” institutions, and that the rule creating multiple clearinghouses in the derivatives space created an implicit competitive playing field that pushes clearinghouses to lower margin and collateral requirements in order to gain market share. And I don’t think this is a good thing. But to force clearinghouses to back up their US Treasury positions with letters of credit backed by US financial institutions seems silly.

Let’s take a step back and look at this with a bit more scrutiny: My US Treasury position at the CME, ICE, LCH, or wherever needs to be backstopped with a letter of credit from a US bank, in presumably US dollars. So in case the US dollar declines in value and/or US Treasuries are not worth the electrons that they are printed on, a letter of credit issued by a US bank will provide the backstop to this collateral deficit?

But if the US Treasury and the US dollar aren’t creditworthy, what would make a letter of credit drawn on a US bank creditworthy? Go back to 2008 when the value of Icelandic debt was dropping like a stone – would anyone want a letter of credit guarantee from even the largest of the Icelandic banks? I could maybe see having a letter of credit guaranteed by a German bank or a US bank in another currency backing Icelandic collateral, but if the currency is plummeting, then the value of an Icelandic letter of credit is also plummeting, and so will the financial soundness of the banks that use that currency.

Maybe I have this wrong, and if so, I would love to be set straight (hint : please comment below).

If we are worried about the soundness of our currency in regards to clearinghouse collateral, then maybe we need to force clearinghouses to have more collateral, or increase clearinghouse members’ default funds. If we are truly worried about an inflating dollar, maybe we need to benchmark the US dollar risk associated with clearinghouse margin against not only US sovereign risk but also in relation to GDP, the euro or a basket of international currencies and force daily (or intraday) revaluations of collateral based upon a standard measure?

But saying that my US Treasury position needs to be backstopped by a US bank to protect against a sliding US dollar doesn’t make sense. If the dollar is in free-fall, how much would a US bank guarantee be worth?