The future of the global financial system?
The future of the global financial system? Reuters

Less than 24 hours after the U.S. government reported it was mostly done with its unprofitable bailout of AIG, a Bloomberg News article out Tuesday explained how Wall Street banks are setting themselves up for the next systemic crisis by playing at financial alchemy in the derivatives market.

In an enlightening take on a topic that hadn't previously seen the light of day in most mainstream media outlets, the article explained how U.S. banks, in an attempt to help clients skirt the intent of yet-to-be-implemented market regulations, are setting up a mechanism that will allow financiers to bet on complex derivatives using other people's borrowed collateral.

First, a primer on how the derivatives markets work: When traders want to wager on risky synthetic derivatives -- which are, essentially, bets on expected future outcomes in the market for things like interest rates, stock indices and weather patterns -- they can either settle their positions on an honor basis or ask that collateral be set aside as counterparty insurance. In other words, they can either trust that the person taking the opposite side of the bet will actually have enough to pay up at the end of the transaction or, using a third-party clearinghouse, demand that the person put their money where their mouth is.

In cases where the latter course is chosen, the clearinghouse guarantees both sides of the trade, taking a fee for the trouble, and sets up the guidelines as to what kind of assets it will accept as collateral. Generally, only the 'safest' of assets -- U.S. government-backed bonds, very high grade corporate notes or cash -- are accepted.

Prior to this year, traders used to be able to avoid this arrangement, choosing instead to trade "over the counter," and setting their own parameters for what collateral would be demanded from their counterparties, if any. The upshot to this strategy was that traders could use the very assets that would have otherwise sat in segregated accounts as collateral to back other positions. The downside was, of course, the possibility that the firm taking the other side of the trade would claim it didn't have a way to settle its wager when it was time to pay up, something known in the world of finance as counterparty risk.

Counterparty risk brought the financial system to its knees in 2008, when American International Group (NYSE: AIG) was unable to post enough money to back bets it had made insuring sub-prime mortgage bonds. So, to avoid that situation from ever happening again, lawmakers used the Dodd-Frank financial regulatory overhaul to force much of the activity in the derivatives market to be conducted through a clearinghouse.

Wall Street has bucked at complying with the spirit of the regulation, which is supposed to go into effect before the end of 2012. The clearinghouses, one of the most important of which is owned by a consortium of banks anyway, have begun by chipping away at the quality they say they will require in pledged collateral assets, saying they will begin accepting lower-rated bonds and other more exotic instruments like physical gold to back trades. But since those institutions can only go so low before their collateral standards become worthless, other, more creative solutions are also being sought.

Enter "collateral transformation": The idea is to allow people who want to be able to trade derivatives -- but who don't have enough collateral-worthy assets -- to be able to walk into some willing institution, dump a bucket of highly risky assets like "junk" bonds or illiquid private company shares, and come out the door with a pile of high-value assets like U.S. Treasury bonds.

Collateral Transformation (TABB Group)

It's the high-finance world equivalent of pawning your gold jewelry for cash, then using that cash to secure a large line of credit at the casino, then hitting the craps table. The difference, of course, is that if an individual pursued such a reckless endeavor in real life, it could ruin only the individual and his credit score, whereas "snake eyes" in the case of high finance could bring down the entire global financial system.

"We just keep piling on lots of operational risk as we convert one form of collateral into another," Richie Prager, global head of trading at New York-based BlackRock, the world's largest asset manager, told Bloomberg, sounding a note similar to those of many Occupy Wall Street activists.

The main adverse scenario envisioned by experts is a possible collateral crunch crisis, where either high stress in the financial markets or a specific event affecting a number of counterparties causes the institutions with lent-out collateral to ask for their assets back. If the event is occuring because of a third-party shock, such as a banking panic or major default, the people engaged in various trades might not be able to unwind their positions in time. That was the situation -- a nightmare condition for a credit system built on trust -- that brought down Lehman Brothers and knee-capped Bear Stearns in 2008. And it would have toppled AIG had it not been for Uncle Sam's staying hand.

It is not clear how big of a business collateral transformation could be, although Bloomberg suggests Wall Street's cash-for-clunkers industry could well involve hundreds of billions of dollars, as some estimates have traders requiring $2.6 trillion in additional collateral to settle their positions once the new clearinghouse-focused regime goes into place.

Besides the obvious, an additional pitfall in the newly-created market for transformation services will be that many firms will hire an outside consultant to manage the collateral alchemy for them. A 2011 Citigroup report cites Stewart Catt, an associate at Mercer, an investment consultancy, who noted that "many of the bigger names will build up their operations in-house. But the mid- to smaller-tier players will consider outsourcing. If you have anything less than $100 billion under management you should probably take this route." In other words, even more players, more complexity, more obscurity.

"Provision of collateral transformation services could potentially magnify large banks' systemic importance in derivatives transactions, further complicating financial linkages among large institutions. They could also add complexity and blur transparency around relatively straightforward transactions," French ratings agency Fitch wrote in a notice earlier this year warning clients that it was keeping an eye on developments. "This could increase transaction costs and ultimately reduce liquidity in derivatives markets."

Not that the fact will dissuade participants. In a post on one of its corporate blogs, financial services consulting and research firm Finadium recently wrote that while the level of interest in collateral transformation is uncertain, as setting up a workable system might be more complicated than it appears at first glance, the concept itself had "made securities lenders and repo desks salivate" with promises to revive a sector of finance "that hasn't really recovered from Lehman going bust."

According to Bloomberg, Bank of America Corp. (NYSE: BAC), JPMorgan Chase and Co. (NYSE: JPM), Bank of New York Mellon Corp. (NYSE: BK), Barclays Plc (London: BARC), Deutsche Bank AG (Frankfurt: DBK), Goldman Sachs Group Inc. (NYSE: GS) and State Street Corp. (NYSE: STT) are all lining up to provide the service.

Of course, as is almost to be expected, regulators have been caught flat-footed as the idea for collateral transformation has developed.

In the same note that stated the agency's view on the issue, Fitch candidly wrote that while a rise in collateral transformation operations could "potentially cause meaningful balance sheet growth, and would also increase capital and possibly liquidity requirements at the banks" in addition to leading to the proliferation in off-balance sheet accounting trickery, it was "unclear what, if any, regulatory response may result from the growth of collateral transformation."

Indeed, in a 2011 report, consulting firm Deloitte Touche Tohmatsu seemed to say that regulators are nearly an after-thought to firms looking to set up collateral transformation activities, citing only "medium" regulatory risk in this budding corner of finance and suggesting clients should spend their efforts working on "integration across products" and "building an automated solution."

One of the few regulators on the ball regarding the issue has been the Bank of England, Britain's central bank, which has repeatedly warned that "collateral swaps," an existing instrument that is seen as a model to future collateral transformation products, "may amplify stress within the financial system by acting as drains on collateral or liquidity." The institution has referred the issue to the country's market regulator, the Financial Services Authority, which published guidelines as to what kind of swaps would be acceptable. No similar dynamic has occured in the U.S.

Framing the issue in a way even a child -- though perhaps not a regulator -- can understand, Craig Pirrong, a professor of finance at the University of Houston, told market data firm Markit late last year that "the original reason behind clearing mandates was to reduce systemic risk, but collateral transformation is just likely to relocate it. We haven't really fixed the systemic risk problem; we've just changed its address."

A June 2012 report by Alexander Tabb, a partner at market technology firm Tabb Group, puts it in words even a mentally-disabled child -- though, again, perhaps not a regulator -- can understand: "Fasten your seatbelt. It's going to be a bumpy ride."

Wake me up when this movie's over. I already know the ending.