Collateral Transformation came about as a direct result of new regulation requiring counterparties on non-exchange-traded derivatives contracts to put up collateral, despite the fact that such institutions generally do not own high-grade, liquid assets. Via collateral transformation, these institutions exchange their low-grade bond for “more acceptable” assets such as treasruies, which are then used as collateral on derivates contracts.

Q. So we were on with Gary Parr earlier talking about bank business models, and this is a new line of business for them… “collateral transformation” desks. What do they do?
A. This is a direct result of the very good idea that most derivatives should be standardized and “cleared”… one of the really key ideas out there to help prevent another 2008 style freeze of the credit markets. The institutions who are setting up the clearinghouses, though, want the institutions on the hook for the payments under the derivatives contracts to put up real collateral for them.

Q. Well, that would make sense, sort of like future contracts and other exchange-traded options.
A. Right. But, of course, the question is, what sort of collateral? For it to do the job, the collateral needs to be high quality, and liquid. And guess what? A lot of the really enormous users of derivatives contracts don’t have all that much great collateral lying around, at least not so much that they want to tie it up to support their derivatives exposure. That’s where “collateral transformation” kicks in.

Q. Wow, the phrase sure sounds like financial alchemy. How does it work?
A. Well, it’s really an extension of the securities lending businesses these institutions already have. The basic idea is: OK, you’ve got some medium grade corporate bonds there that aren’t good enough to satisfy the derivatives clearing houses. We’ve got some nice Treasuries. So you pay us a fee and give us those corporates as collateral, and we’ll lend you these Treasuries to post as collateral for the derivatives.

Q. So, this whole thing could turn into a big business for the banks, I guess?
A. Very big, given the size of the derivatives market; that’s why they’re already setting up these desks. But of course the not-so-funny problem is pretty simple: there’s an absolute shortage of really high quality collateral out there. Obviously, “transformation” doesn’t change that at all… it just hides where the real problems are, which is exactly opposite the whole idea of having these things listed and cleared in the first place.