Clearing and Collateral Mandates: A New Liquidity Trap?

All too often, legislative solutions to some financial crisis have serious consequences that are both unwanted and unintended. The author of this article foresees several possible negative consequences arising from Title VII of the Dodd‐Frank Act, which mandates that eligible derivatives be cleared through central counterparties (CCPs) that require initial and variation margin. The new legislation also requires that the remaining non‐cleared derivatives that are traded by some market participants be more heavily collateralized. The Act's authors have argued that derivatives pose uniquely dangerous systemic risks because of the leverage and counterparty risk associated with them. Increased collateralization, their thinking goes, would reduce derivatives‐related leverage and the systemic risk to the financial system associated with such leverage. The author argues that these hopes are unduly optimistic because they fail to recognize how market participants can substitute other forms of leverage, such as bank lines of credit or collateral transformation trades, for the leverage derivatives provided previously. The author also believes that the larger collateral mandates and frequent marking‐to‐market will make the financial system more vulnerable since margin requirements tend to be “pro‐cyclical.” And more rigid collateralization mechanisms can restrict the supply of funding liquidity, and lead to spikes in funding liquidity demand that can reduce the liquidity of traded instruments and generate destabilizing feedback loops. The fragmentation of CCPs across jurisdictions and products will lead to greater demand for CCP‐eligible collateral to maintain the same level of hedging transactions. This demand will likely be met by using riskier assets as collateral and encourage the shadow banking system to create new assets that can be posted as collateral (for example, via collateral transformation services). In sum, although the Dodd‐Frank rules are intended to reduce systemic risk, their expected impact on liquidity makes it a very open question as to whether they will achieve this goal. Although they may reduce some risks, they will simply shift others while possibly creating new ones.