Big Banks to Offer Collateral Transformation

Process will let customers swap lower-rated collateral for higher-rated securities; critics worry process will obscure risk.

JPMorgan Chase & Co. and Bank of America Corp. 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.

Central Clearinghouses

The new rules are rooted in the 2010 Dodd-Frank Act, passed in reaction to the near-collapse of the financial system in 2008, caused in part because derivatives contracts weren’t backed by enough collateral. American International Group Inc. needed a $182.3 billion bailout from the U.S. government after the New York-based insurer failed to make good on derivatives trades with some of the world’s largest banks, according to a 2011 report by the Financial Crisis Inquiry Commission.

‘Operational Risk’

Banks could be squeezed if they have borrowed the Treasuries that they’re lending as collateral, and the original lender suddenly demanded them back, said Duffie, the Stanford finance professor.

‘Systemic Bottlenecks’

The exchange decided to accept the corporate bonds because Wall Street firms are under pressure to build capital and probably will face constraints on how much high-quality collateral they can lend, said Kim Taylor, president of the CME’s clearing business.

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