Streetwise Professor

As changes in financial market regulation like Frankendodd lurch into effect (with phase two of the clearing mandate becoming effective a couple of days ago), it’s interesting to see the dawning realization about some of the implications.  Implications that I’ve discussed for several years here, or in my academic work.

One of these is the tension between the micro-prudential and macro-prudential roles of collateral.  Micro-prudentially, collateral makes sense for a lender: it increases recoveries in the event the borrower goes bust.  But collateral is much more problematic macro-prudentially, for a variety of reasons.  It can be a highly pro cyclical mechanism that intensifies the effects of financial shocks.  It can be a crisis accelerator.

Andrew Hauser of the Bank of England focuses on this tension in this speech.  Unfortunately, despite this and other evidence of growing attention to this issue, I still think it’s under appreciated and that will lead to problems down the road.

Another issue is one that I raised in my more cynical moments.  Scary thought, I know.  Specifically, I mused that one reason for the broad political support for clearing and collateral mandates, especially among government treasuries (e.g., Timmy!), is that these were a form of financial repression.  That is, a means of increasing the demand for government securities, in order to reduce interest rates and borrowing costs.  The mandates effectively require market participants to hold more government debt in their portfolios.

Bloomberg just noticed this:

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

Um, unintended benefit for whom?  And who says its unintended?  I think it might have been quite intentional-just not acknowledged.

Now that the regulatory changes are being put into place, we’ll see how good my forecasting performance is.  Since I’ve predicted many unintended consequences, most of which are not good, y’all should hope that it’s not very good at all.  But it appears that others are making similar predictions now, at least on these two issues.