CFTC rules on CCP liquidity facilities: Treasuries need to be covered.

The CFTC, as reported in a Nov. 15th article in Bloomberg “CFTC Passes Collateral Rule to Backstop Treasuries in Swap Trade” by Matthew Leising, followed through on their proposal to require CCPs to have back-up liquidity lines against US Treasuries they hold as collateral. We wrote about this in an Oct. 16th post “The CFTC and liquidity rules for DCOs: do they need committed repo facilities for their US Treasuries?”. This could be a big deal.

If a CCP has to monetize large quantities of US Treasuries and markets simply aren’t functioning, they will be able tap the liquidity facility to generate the cash they need. This is real doomsday stuff. But will the providers of those facilities be able to handle it? The last default debacle showed us anything is possible. But – lets be practical here — expecting banks to provide cash when the UST market can’t does seem a bit silly. Maybe this is all about same day cash versus T+1? Government markets are less liquid if you need to get paid cash today as opposed to regular 1-day settlement — but it seems a difference without a distinction. Won’t a crisis clobber the banks first?

When a bank is asked to offer a liquidity line, one thing they think about is if this is really a put of the underlying collateral to the bank? Notwithstanding that these are US Treasuries, if a bank has to give liquidity, they may want to hedge that risk by buying CDS protection. This will inform the fee charged (and haircut demanded) for the facility. The bank could simply assume there will be same day liquidity and not charge a (CDS driven haircut adjusted) fee, but is that the right approach? This facility will be expensive and costs will be passed on to clients.

The rules require the CCPs have access to “qualifying liquidity resources”. From the CFTC document outlining the final rule “Derivatives Clearing Organizations and International Standards 17 CFR Parts 39, 140, and 190, RIN Number 3038-AE06” describing what is meant by a committed line of credit, committed foreign exchange swap or a committed repurchase agreement:

“… ‘Committed’ is intended to connote a legally binding contract under which a liquidity provider agrees to provide the relevant liquidity resource without delay or further evaluation of the DCO’s creditworthiness, e.g., a line of credit that cannot be withdrawn at the election of the liquidity provider during times of financial stress, or in the event of the default of a member of the SIDCO or Subpart C DCO…”

One institution suggested that the agreements should include Material Adverse Change (MAC) clauses. So if there was some sort of crisis, the liquidity line could be pulled. The CFTC said “no way”. They ruled:

“…Under proposed paragraph (c)(3)(ii), a SIDCO or Subpart C DCO would be required to take appropriate steps to verify that its qualifying liquidity arrangements do not include material adverse change provisions and are enforceable, and will be highly reliable, even in extreme but plausible market conditions…”

Will the securities simply end up back at the Fed using a lender of last resort facility? If that is the case, then why not take the liquidity provider institution out of the equation and have the Fed say they will provide liquidity in a specifically designed program? Think of it as the opposite side of the Fed’s overnight fixed-rate reverse repurchase agreement. If large CCPs are SIFIs, can’t they rely on LOLR access? Wait until the politicians get a hold of that one…

The CFTC noted, the “…CME stated that this provision would necessitate CME to limit the amount of U.S. Treasury securities a CME-clearing member could deposit to meet initial margin and guaranty fund obligations. To compensate, the clearing members would have to deposit additional cash…” This is likely true and it will be interesting to see how CCPs change the mix of acceptable collateral. In any event, it seems like efforts in the U.S. to broaden out collateral – more corporates and the like – will get stopped in their tracks. The real brunt won’t be felt until interest rates rise and the returns on the cash sitting at the CCPs start to compare unfavorably with other options. It can also materially change the way investment portfolios are managed. Keeping all that cash at the CCP acts to de-lever the portfolio and may be at odds with the reasons behind using derivatives in the first place.

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