Investors may find fewer places to hide when the next bear market comes, according to the Wall Street Journal. American and foreign regulators' push for safer, more responsible trading is sharply reducing the supply of safe assets such as Treasuries and German bonds, experts say. That's because regulators, in the wake of the financial crisis, are forcing big investors to use clearing houses, which handle hundreds of billions of dollars in cash collateral—and are in effect vacuuming up safe assets from the market by exchanging cash for high quality assets. (For more, see also: Why America's Big Creditors Are Selling Treasuries.)
Regulation and Clearinghouses
One criticism leveled at Wall Street in the aftermath of the 2008 financial crisis was that so-called over the counter (OTC) trading led to systemic counterparty risk which rippled throughout the financial sector when the housing bubble burst. One solution was for governments around the world to mandate central clearing of all trades through clearing houses to minimize that sort of risk. Banks and other financial institutions put up margins at the clearing house, in the form of cash, but the clearing house in turn must put that cash to use, and does so by purchasing low-risk assets.
The Wall Street Journal writes that these crucial pieces of financial infrastructure cannot simply leave the cash in bank deposits since that would simply return the cash margin back to the banking sector. Instead, these clearing houses are sucking up "safe" assets such as sovereign debt including U.S. Treasuries. Some clearing houses are even faced with mandates to only keep a small amount of cash on hand. According to the WSJ, "European clearinghouses are only allowed to leave 5% of it in bank deposits. Some of them can park part of it in the eurozone’s national central banks, but many remain active participants in overnight repo markets." (For more, watch: Central Counterparty Clearing House.)
With sovereign debt markets experiencing volatility lately amid Brexit and the Trump election, some fear that these "too big to fail" institutions may be on rocky ground. The Financial Times suggests that in the worst case, "there are only four possible parties on the hook: the clearinghouse’s shareholders, normally big exchanges; the clearinghouse’s members, usually the big banks; customers of the clearing house members, like fund managers; or the government or taxpayer. Policymakers are united that it will not be the taxpayer."
Central Banks and Safe Assets
Following 2008, central banks also began to vacuum up trillions of dollars worth of sovereign debt around the world amid quantitative easing (QE). Some fear that since we are now in a growth disposition, the Fed and other central banks may begin to unwind their massive positions in government bonds, depressing their prices, and putting a further strain on clearing houses' balance sheets. Fed chair Janet Yellen, however, has hinted that her strategy to reduce the Fed's holdings will be simply to let these bonds mature and not use the interest received to purchase new debt. (For related reading, see also: Trump Allies Attack $4.5 Trillion Fed Balance Sheet.)