by Kyle Colona on September 14, 2012
As many in the banking world know, the Dodd-Frank reforms aimed at the swaps markets require derivative transactions to be conducted on a clearinghouse. This means that traders will need to post collateral while regulators will have a better shot at policing this $multi-trillion market.
However, a recent BusinessWeek story suggests that that some of the country’s largest banks already have a plan to help clients work around the measure via a big loop hole.
In short, the game is for traders to repackage high risk securities into the high-grade bonds that clearinghouses require traders to post as collateral.
The argument goes that “temporarily” swapping lower-grade securities for high-grade bonds such as Treasuries will be a boon for traders and the banks because traders have the quality collateral required while the banks collect fees and interest for lending.
But this is still a risky game because if traders go bust the banks will be stuck holding risky bonds instead of high-grade securities. Moreover, if the banks borrow the high-grade bonds, the original lender could set off a ripple effect through the market by re-calling the collateral.
Obviously this could trigger a downward spiral that the Dodd-Frank reforms are supposed to prevent.
Of course, banks contend that swapping collateral does not shield them from risk because the banks are regulated and still have to adhere to capital requirements. This, in turn, means that there are lending limitations that can mitigate their losses in the event that a trader goes down.
Further, bankers contend that “collateral transformation” is not as risky as it looks because it is a short-term lending scheme that must meet tight capital and liquidity rules. Further, these rules are becoming even tighter by way of other Dodd Frank reforms as well as the Basel III accord that is built on much stricter capital requirements.
In the final analysis, regulatory measures historically have loop holes built into them. But the question remains as to who will get caught in the downdraft of the next financial crisis.
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Kyle Colona is a New York-based freelance writer and a Feature Writer for CompliancEX and the Wall Street Job Report. He has an extensive background in legal and regulatory affairs in the financial services sector and his work has appeared in a variety of print and on-line publications. You can find him on linkedin.