Bank of America office

(Bloomberg)

JPMorgan Chase & Co. (JPM) 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.

The solution: At least seven banks plan to let customers swap lower-rated securities that don’t meet standards in return for a loan of Treasuries or similar holdings that do qualify, a process dubbed “collateral transformation.” That’s raising concerns among investors, bank executives and academics that measures intended to avert risk are hiding it instead, reports Bloomberg.

“The dealers look after their own interests, and they won’t necessarily look after the systemic risks that are associated with this,” said Darrell Duffie, a finance professor at Stanford University who has studied the derivatives and securities-lending markets. “Regulators are probably going to become aware of it once the practice gets big enough.”

Adding to the concern is the reaction of central clearinghouses, which collect from losers on derivatives trades and pay off winners. Some have responded to the collateral shortage by lowering standards, with the Chicago Mercantile Exchange accepting bonds rated four levels above junk.

The potential reward for revenue-starved banks is an expanded securities-lending market that could generate billions of dollars in fees. JPMorgan and Bank of America, which have the biggest derivatives businesses among U.S. bank holding companies with a combined $140 trillion of the instruments, are already marketing their new collateral-transformation desks, people with knowledge of the operations said.

The list also includes Bank of New York Mellon Corp., Barclays Plc (BARC), Deutsche Bank AG (DBK), Goldman Sachs Group Inc. (GS) and State Street Corp. (STT), said the people, who asked not to be identified because they weren’t authorized to speak publicly.
Derivatives allow buyers to bet on the direction of currencies, interest rates and markets to protect their holdings, insure against defaults on bonds or lock in a price on commodities. More than 90 percent of the trades are privately negotiated, according to the Bank for International Settlements. That exempts them from the rules of futures exchanges, which require an initial collateral posting as a good-faith deposit to ensure bets are covered. Traders have to post more collateral, usually in cash, when positions move against them.