Panic in Europe? Over a U.S. debt default? Surely not … well, maybe. Just a little.
OK, quite a lot, to judge by an awkward exchange at the International Capital Markets Association’s annual bash in Paris on Thursday.
“My question,” AXA Investment Management fixed-income chief Hans Stoter told a panel discussing the issue, “is if T-bills are no longer accepted as collateral, won’t the whole system collapse?”
It’s the question on everybody’s mind, of course. The U.S. Congress has until June 1 to put aside its differences and raise the debt ceiling. Very soon after that, the federal government will run out of cash to pay its running expenses.
But few are they who dare look into the abyss to find the answers.
The FT’s Katie Martin, who was moderating the panel, laughed uncomfortably and put the question to Christophe Hémon, the CEO of LCH SA, a clearinghouse that, in its capacity as middleman between lenders and borrowers, holds billions of euros worth of Treasury bills as collateral for yet more billions worth of loans.
Stoter’s implication was that failure to agree by then will render all that collateral null and void. The implication is a bit misleading, however, as Treasury debt has no cross-default clauses, meaning that a default on one issue doesn’t put the whole stock of Treasury debt officially in the bond market doghouse.
Hémon pointed out that the continental European part of LCH’s business actually doesn’t hold any U.S. debt. Stoter, who probably heard an echo in those words of all the times that Europeans said they were immune to a crisis in U.S. subprime mortgages, wasn’t satisfied, however.
“So LCH won’t collapse, but the system?” Stoter quipped, to borderline hysteria from the gallery. To which Hémon acknowledged that LCH’s London franchise does, indeed, hold a ton of the at-risk bonds. “That will of course be a situation to face,” he said with some understatement and a commendably straight face.
POLITICO caught up with Stoter outside the ICMA venue, the sumptuous Palais Brongniart, to expand on his take. The biggest problem in the market at the moment, he said, is a kind of institutional paralysis.
“Nobody’s willing to be a hero,” he said, adding — somewhat cryptically — “the best thing is to stay close to home — whatever a home is.”
Nobody, as far as he is aware, is making any big bets in any direction. Instead people are heading to cash as a safe haven. “Money is not made by being aggressive at the moment,” he said.
In the panel, Stoter had pointed out that the farce over the U.S. debt ceiling happens with basically every new budget. It’s like in “Groundhog Day,” he said, but whereas in that movie Bill Murray “learns something new every day and gets a little better,” in this case the “U.S. is going in the other direction.”
Solutions in sight
ICMA conference-goers generally seemed to doubt that a default could lead to the U.S.’s debt never being paid. It’s at no serious existential risk like, say, revolutionary Russia was, and any default would be largely the consequence of resolvable congressional pedantry. As such, those forced to hold their Treasury debt throughout the standoff can still be pretty sanguine about the long-term outlook.
But the disruption it would cause would surely have far-reaching effects in every corner of financial markets — not least in the area of collateral management. Anything that devalues the promise of regular payment forces market participants to come up with ways to manage the risk of not being paid.
Some investors, for instance, “bake in” exclusions for certain kinds of debt — say, defaulted debt — into the software they use to trade, often loosely referencing non-binding international standards of the kind promulgated by the ICMA, according to one helpful collateral management software vendor who was granted anonymity to protect the identity of his loved ones.
That would mean in the event of even a minor U.S. default, creditors’ software could “automatically ‘say no’” to an attempted transaction involving U.S. Treasuries, the vendor added. (It’s not always automatic, though — many exclusions are administered manually. And by extension, the software could be tweaked to allow those issues not in default to continue flowing freely.)
These kinds of baked-in agreements are mostly the preserve of middlemen who post collateral on behalf of lenders and borrowers involved in short-term “repo” lending and who don’t have the resources to stump up the collateral themselves. Any kind of asset can be excluded. It’s common, for instance, for collateral managers to say, “‘Don’t give us Nigerian bonds,’” said one repo market analyst, who also asked not to be named.
But if everyone has different baked-in preferences (known as “eligibility schedules”) how does a diverse group of investors agree quickly on what kind of debt to accept in order to keep markets moving?
One tentative solution, ICMA Senior Adviser Godfrey de Vidt said, could involve, well, “distributed ledger technology,” which means a ledger shared by a select group of private stakeholders, or, uh, a blockchain. Access to such a ledger apparently makes it easier to adjust eligibility across a large group of transactors, and, De Vidt says, is already used in countries like Greece.
There is, however, a likelier — and much lower-tech — workaround. The most likely scenario is Europe’s financiers will just use central bank reserves — a.k.a. regular dollars — as collateral instead, and the wheels will keep on turning.
