Repo gets all of what tiny little bit of attention the world might pay (pun intended) to collateral. It shouldn’t be the sole star of this deeper shadow money world. There are other segments on the inside which gobble up collateral use, some of which might have even surpassed repo in terms of potential flashpoints if not overall importance to the smooth flow of the world’s ridiculously fickle private bank money reserve system.
What are those other segments? Derivatives. Some of these others act in every way, in every bit as if cash and credit. While I don’t intend to get too heavy into them here, forex, mainly, there is much to be learned from derivatives as a group to understand just how collateral has become a centerpiece component for the global monetary arrangement.
The operation of that arrangement requires specialized firms to be the bank in this private bank money reserve system; there’s little to no place for what are wrongly today identified as central banks. Instead, these modernized unicorns of what grew up from the ancient – and once-separated – commercial banks, securities dealers who don’t just deal securities.
To begin with, derivative contracts and transactions require collateral, both initial margins put up front and then variations (though mostly as margin cash) as prices change over time given the ultra-dynamic and fast-paced world we and financial markets inhabit. This collateral requirement was made more onerous, unsurprisingly, when governments asleep before 2009 suddenly awakened in 2010 offering a whole range of, ahem, “solutions” to the devastating deflation the whole planet had already suffered.
Completely misunderstanding what had happened, believing the media and the story about subprime mortgages put forward by derelict regulators and policymakers all over the government spectrum, they pushed hard for what’s today called central counterparty clearing (CCP). It was a mandate which brought with it a higher collateral requirement.
Previous transactions of the same type weren’t uncollateralized, as much as it is made to seem the whole thing used to be the Wild West (because there was a lot that was), though routing everything via CCP has upped the systemic obligation – and yet, no one talks about this.
Instead, in attempting to analyze and explain why “things” continue to go wrong, how drastic often serious “anomalies” continue to pop up with alarming regularity, fingers (and knives) are immediately pointed at balance sheet coverage directives; regulatory demands such as the SLR, or Supplementary Leverage Ratio.
Some wish to highlight and condemn the unintended consequences of bureaucracies running amok and enforcing their academic schemes in inappropriate ways to actual practice, while others cannot conceive of private motivations and shortfalls outside of their everything-that-happens-must-be-because-government worldviews.
This is a very long way of introducing interest rate swaps (IRS) and their persistent – and persisting – irregularities, and why these matter more right now than maybe ever before (yes, I’m exaggerating but not really all that much).
As I’ve chronicled countless times in these same pages, a negative swap spread is an assault on basic common sense let alone standard financial principles. Getting paid a lesser fixed rate interest from some IRS counterparty than you might receive on the same maturity US Treasury is plain bonkers (the difference between those two is this spread in question). Either you believe the US government is a greater risk than the financial counterparty, or there’s something else going on here.
Obviously, there’s something else, a lot of something else, going on here.
And it isn’t just me saying this. Forget the macro interpretation, a negative (or even “too” low) swap spread represents an opportunity for someone, not you or me, of course, to profit from this nonsense. But how?
There are several possible ways, and here I’m purposefully going to use a method described in really good detail by Nina Boyarchenko, Pooja Gupta, Nick Steele, and Jacqueline Yen in their October 2018 FRBNY article simply titled, Negative Swap Spreads.
“In particular, if a market participant anticipates that swap spreads will move closer to historical levels, they could enter into a pay-fixed swap while simultaneously holding a long Treasury position of matched maturity. The pay-fixed swap insures the participant against potential future interest rate fluctuations. If the Treasury and the swap have equal risk profiles along all other dimensions, such as counterparty and liquidity risk, this trade represents an arbitrage opportunity in which the market participant earns the Treasury coupon and the three-month Libor from the floating leg of the swap and pays the fixed swap rate and the general collateral (GC) repo cost to finance the Treasury holding.”
If you didn’t quite catch all that, it really all breaks down to where you reverse engineer the transaction to take advantage of what’s not in balance – the fixed leg of the swap is too low relative to the nominal US Treasury yield. Therefore, essentially, buy the Treasury (long) and short the swap (fixed).
Here’s the thing, and it’s one that the trio of authors correctly zero-in on: it may be an arbitrage opportunity but that doesn’t mean it is completely frictionless. As Boyarchenko et. al. diagram and detail, going long the UST means giving up balance sheet space on both sides, assets (holding the UST) as well as liabilities (a repo along with unsecured to pay for the UST’s haircut in repo).
Basically, because it costs balance sheet capacity to arb a negative swap spread, if dealers as a group find balance sheet capacity more expensive, they will require a much fatter arbitrage opportunity, a much more favorable or negative swap spread, to make the whole effort worth giving up that too-precious balance sheet space volume.
Predictably, because FRBNY, they blame the Basel 3’s official bogeyman for this:
“Although we cannot precisely measure the costs SLR capital requirements impose, it appears that executing swap spread trades is now more expensive for dealers than in the past largely because of the amount of capital that dealers must hold against these trades…As a result, while current negative swap spread levels may have presented attractive trading opportunities in the past—which would have reduced deviations from parity—our analysis suggests that, given the balance sheet costs, these spreads must reach more negative levels to generate an adequate ROE for dealers.”
Those in official or regulatory positions never seem able to wrap their heads around private considerations surrounding and superseding their preconceived motivation. Maybe (though not maybe) it’s not the SLR – or SLR alone - which has made balance sheet capacity so much more expensive than in the past.
There are a myriad of internal calculations and considerations which would disqualify the same set of transactions; everything from quite simple internal liquidity constraints (limits placed on how much repo by banks having come to understand and vividly confront vulnerabilities to over-use and heavy dependence upon short-term wholesale like repo long before anyone in government had learned what short-term wholesale was) to, yes, collateral availability.
The authors and their conclusion attempts only to explain why recent swap spreads (defined as after the SLR being imposed to start 2014 up to publication in October 2018) would, given the rate hikes by the time of publication, fail to decompress as they really should have.
What about swap spreads before 2014?
Our anomaly-filled global private bank money reserve system has been sporting the same IRS problem ever since October 2008; already a clue. But why do these fluctuations in low spreads getting lower or more negative during specific periods continue to happen, and do so quite frequently? Especially given all those trillions in post-GFC bank reserves (one reason why academic and government researchers refuse to consider anything except regulations).
Referencing the particular outbreak of compression in IRS spreads during 2015, all the authors would say about it is, “exogenous factors.”
“We do not argue that it is the higher leverage ratios themselves that have narrowed spreads. Instead, when exogenous factors narrowed spreads, the leverage requirements reduced incentives for market participants to enter into trades that would have counteracted the effects of exogenous shocks. The exogenous factors that market participants have identified as narrowing spreads since fall 2015 include notable selling of foreign reserves by foreign central banks, particularly China; increased swapping of fixed-rate into floating-rate debt; and increased demand by insurance and pension funds to match the extending durations of their liabilities as longer-term government yields declined.”
Wait, what was the first one of those, that thing about China?
In truth, this commendable if incomplete examination of the swaps market has almost connected some larger macro dots to what they had already uncovered in small scale. Balance sheet incapacity for whatever reason(s) is an easily established explanation for lack of forthright arbitrage behind spread behavior, limited to that arbitrage as these three find.
Why did spreads move down in the first place? Sure, once down they tend to stay down, and that’s not unimportant. There’s more to the story here, more dots to connect.
Going further, it takes very little effort to notice and chronicle how IRS spreads have moved down in sequence with other market indications, including those closely aligned with China’s 2014-15 “notable selling of foreign reserves.”
Centrally cleared IRS are more highly collateralized than they had been under bilateral or multilateral shadow arrangements. Any number of studies had uncovered the far more informal and friendly business-like arrangements of the pre-crisis era. Here’s one from the BIS in 2012 (BIS Working Papers No 373, Collateral requirements for mandatory central clearing of over-the-counter derivatives).
“CCPs do often demand more collateral than under decentralised arrangements to clear equivalent positions, as they require collateral to cover both current counterparty exposures (variation margins) and the vast majority of potential future exposures that could arise from valuation changes (initial margins and default fund contributions). In contrast, decentralised clearers presently [2012] often forego collateral against potential future exposures under current arrangements and sometimes waive collateralisation of current exposures for certain types of counterparty, including sovereigns and non-financial companies.”
CCP’s, whatever good they might do, here in terms of collateral prerequisites they make the whole collateral system flow more rigid and, oh yes, inelastic. Where dealers might have responded in more benign situations with understanding and leeway (“sometimes waive collateralization of current exposures”) CCP’s are robotically bureaucratic in their demands.
That sort of rigidity gets factored and then multiplied in dealer considerations of their own balance sheet costs (unrelated, obviously, to the SLR or anything in Basel 3).
On the small-scale, this is also a key factor of the IRS arbitrage the FRBNY authors omitted. Focusing on the long UST side of it (for obvious reasons), to complete the arb requires participating in the IRS which therefore means being cleared via a CCP – which means putting up more initial collateral to get it started (don’t get me started on collateral hysteresis).
Meaning, it takes both balance sheet capacity along with collateral in order for the dealer to even think about arbitraging any negative or low swap spread.
As we know, officials, regulators, and especially central bankers struggle to understand or even contextualize systemic collateral shortages as well as how increasingly scarce balance sheet capacity goes hand-in-hand with them in creating conditions when “notable selling of foreign reserves” by China and everyone else happen regularly.
These are very easy to establish; the close correlation between this type of performance in IRS spreads with T-bill yields or flattening curves, the rapidly rising US$ exchange value, as well as the noteworthy but not really exogenous foreign selling or mobilization of their US$ reserves. March 2020 immediately springs to mind.
After all, if collateral becomes scarce (its multiplier drops, for example), not only would that induce an overall deflationary, tight-money collateral ripple systemwide then leading to “notable selling of foreign reserves” which correlates with falling IRS spreads, at the same time it prevents dealers from arbitraging those same spreads (meaning they fall more than they “should”) to moderate the resulting nonsense. It explains both why IRS spreads fall in the first place, before then failing to come back up to any substantial degree.
There is a symmetry between the quantum level (for lack of better terminology) of microscale individual transaction relationships and those very much the same on the macroscale. The monetary theory of everything here being the very nature of eurodollar money. And that is private bank money produced by balance sheet capacities and including collateral sufficiency.
Where does the Fed fit anywhere in here?
As you’ve no doubt already figured out, swap spreads must be compressing again and they are. Those maturities already negative (the 30-year, notably) are becoming more negative and have since back on December 1 (the very same day the eurodollar futures curve first inverted). Other maturities that have been “too low” have compressed lower still (the 10-year maturity having hit zero a couple times more recently).
Given the Fed’s aggressive rate hikes set out just this week and everyone, allegedly, at least outside of these markets, being convinced of inflation, by those two propositions IRS spreads really should be wildly, equally as aggressively decompressing; but aren’t.
Where are the dealers? Balance sheet and collateral constrained (see: T-bill yields). Big picture and small. Quantum and macroscopic.
It isn’t the Fed’s theater of rate hikes which are leading the world down a more dangerous monetary therefore financial then economic path, as the rest of the marketplace agrees. Here with the swap market, we get a good sense as to why.
And it’s not the SLR to blame for all these nonstop monetary missteps. On the contrary, this same treacherous route is easily recognized and recognizable in something so complex and seemingly unintelligible as IRS spreads.
The more nonsense they appear to produce, the more they make perfect sense.
