There have been a handful of articles in recent days about UK regulators scrutinizing collateral upgrade trades. One issue the FSA seems to be concerned about is the ability of the receivers of lower quality collateral to manage the risk. Active collateral management is going to be very important.
We wonder if the point the FSA is really making is that collateral upgrade trades create a potential shell game: the risk is simply moved around, perhaps to those who may not realize what they are signing up for? This has all the classic inter-connectedness and wrong-way risk issues written all over it.
If collateral upgrade trades are constrained, the knock-on effect will be to 1) exacerbate the shortage of high quality collateral for posting with CCPs and 2) make life more difficult for banks managing their Liquidity Coverage Ratios (LCR). For those derivative players who need to post at CCPs, the result may be to force them to shift their investments to owning more CCP-eligible lower yielding sovereign debt than they would have otherwise preferred, reducing portfolio yields. On the LCR side, it will become harder (read: more expensive) for banks to hold non-high quality liquid assets (HQLA), either for their own books or financing for others.