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CFTC Passes Collateral Rule to Backstop Treasuries in Swap Trade

The U.S. Commodity Futures Trading Commission approved a rule aimed at ensuring that Treasuries pledged as collateral for swaps and futures trades can be instantly converted to cash.

With today’s vote, the nation’s main derivatives regulator toughened safeguards in a market blamed for worsening the 2008 global financial crisis. The four commissioners didn’t change language mandating that Treasuries be subject to a “prearranged and highly reliable funding arrangement,” according to a copy of the rule on its website.

The derivatives industry argued that the backstop to Treasury collateral was unnecessary because U.S. government securities can be converted into cash fast enough. While U.S. debt is considered to be among the safest investments, policy makers are concerned liquidating them will require too much time -- up to a day -- during a crisis, a government official familiar with the stance at the Federal Reserve, which shares oversight of clearinghouses, said earlier this week.

The 2008 crisis developed so rapidly that the Fed had to give out more than $2 trillion in emergency aid. Fed officials have told banks and exchanges that the CFTC’s new collateral rule means U.S. debt must be covered by credit lines, according to three industry executives briefed on the matter.

“CME estimates that liquidity facility costs would approximately double” under the rule, according to a Sept. 16 letter that CME Group Inc., the owner of the Chicago Mercantile Exchange, sent the CFTC. “These increased costs would likely either be passed on to end customers or cause many clearing members to exit the customer clearing business entirely.”

Global Standards

Gary Gensler, chairman of the CFTC, said in an interview in New York yesterday that while he doesn’t envision the rule putting a dent in the Treasuries market, “there is some cost to the clearinghouses.”

The goal is to align U.S. clearinghouses with international rules, Gensler said. The change affects collateral posted in the swaps and futures markets, where outstanding contracts have a notional value of about $430 trillion, he said yesterday.

The CFTC worked with the Fed on the rule because the 2010 Dodd-Frank Act mandates that the central bank oversee systemically important financial institutions such as major U.S. derivatives clearinghouses. International regulators last year set broad standards for how clearinghouses treat the collateral they hold as protection from member defaults.

More Collateral

The Dodd-Frank Act required most swaps to be backed by clearinghouses for the first time after the contracts helped cause and intensify the credit crisis of 2008. That means swaps users will have to post $800 billion to $4.6 trillion in additional collateral to meet the new regulations, according to estimates from the Treasury Borrowing Advisory Committee.

Stiffening funding requirements for Treasuries is the latest in a series of actions taken by regulators to rein in the swaps market, frequently to the dismay of traders who say the rules make it unreasonably difficult to do business. The goal is to avoid meltdowns like the ones in 2008 that triggered American International Group Inc.’s $182 billion bailout after the insurer couldn’t make good on its trades and almost destroyed the world’s biggest banks.

Clearinghouses, which are capitalized by their bank and brokerage members, are meant to lessen the effect of a default by requiring collateral and marking positions daily so losses don’t snowball. Initial margin is pledged to fund a potential default while variation margin is required when positions lose value. If investors can’t meet their margin calls, the positions are liquidated.

To contact the reporter on this story: Matthew Leising in New York at mleising@bloomberg.net

To contact the editor responsible for this story: Nick Baker at nbaker7@bloomberg.net

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