United States Debt Ceiling Standoff Creates Tremors in Collateral Markets
- By Todd Hodgin
- May 9, 2023
- Blog Collateral Eligibility Collateral Management Inventory Management
For decades the collateral markets have operated on a simple premise: collateral with short maturities from high-quality issuers is preferable to collateral with longer maturities from issuers with lower credit quality. This assumption helped participants mitigate the risk that collateral would decrease in value by accepting collateral with short maturities from sovereign issuers with high creditworthiness. As firms accept broader types of collateral, they seek to mitigate liquidity and credit risks with increased haircuts, more onerous eligibility criteria, and more frequent margining. However, the recent stalemate on the US Debt Ceiling has begun at least a short-term rethink of that basic notion.
The stature of the United States in the markets has always been evident. The US Dollar has long enjoyed the status as the dominant reserve currency and is used to price a variety of financial assets and commodities across global markets. The low credit risk of the US Government, and the use of the dollar as the global reserve currency, have allowed US debt to be considered a “risk-free asset”. From a credit risk perspective, the prevailing US Treasury rates are used as the risk-free rate for financial analysis and valuation of many assets. Therefore, US Treasuries were often widely accepted as collateral under securities finance transactions, CCP exposures, and as bilateral derivative margins. Treasuries often enjoy the lowest haircuts under those contracts with few limits on the amount allowed as eligible collateral.
As the US has approached the debt ceiling, where no additional borrowing would be allowed under current legislation, market participants have begun to plan for a variety of potential outcomes in the collateral markets. They are evaluating the potential risks of the US failing to increase the debt limit. One risk being discussed is what will happen to short-term T-bills if there is uncertainty about whether the US can meet its short-term obligations. Participants are game planning what would occur if counterparties instituted a brief pause in accepting T-bills, a downgrade of US Debt leads to collateral becoming ineligible, or an increase in the haircut on that collateral is warranted during this hopefully brief period of turmoil. This of course runs counter to the long-time notion that high-quality, sovereign debt with short maturities, is always preferable to other assets.
Firms can use a variety of capabilities to monitor changes in the market and prepare for this potential event. Visibility into changes in collateral eligibility under counterparty agreements is one critical capability. Firms can use a comprehensive collateral eligibility framework to gain access to Triparty, CCP, and bilateral agreements to monitor for changes in their governing agreements that may limit the eligibility of short-dated Treasuries. Additionally, transparent access to margin activity can help market participants know where they are accepting these assets, and under what haircuts, in the event they need to take steps to mitigate potential risks. Lastly, firms are using eligibility and optimization solutions to better understand outlets for these assets if certain counterparties no longer accept them or increase haircuts. If counterparties continue to post these asset types, a comprehensive eligibility and optimization solution can help evaluate intra-day where a firm can route that collateral for the best use for their own obligations.
As participants look for solutions to manage through events that change the funding and collateral markets, Transcend continues to partner with firms to offer modular-based solutions to comprehensively manage their collateral eligibility, collateral balances, and margin activity. This period of uncertainty will pass; however, firms should continue to invest in solutions to effectively manage these risks.