Following Standard & Poor’s decision to downgrade Spanish sovereign debt, the risk of a collateral shortfall in markets has increased again after the regulatory boost to ‘safe assets’ by new requirement for OTC derivatives transactions, advisory firm Rule Financial warned.

Banks demand ‘safe assets’ to support their funding processes in the repo and securities lending markets, and will be explicitly required under the Basel III capital adequacy framework to increase liquidity buffers, in which government bonds will figure prominently, said Jonathan Philp, specialist in OTC clearing and collateral management at the firm.

“Although the US, which has been threatened with downgrading by Moody’s, looks safe in the near term at least, smaller sovereign issuers facing fiscal problems can suffer a compounding effect of higher debt costs if their bonds drop out of the ‘safe asset’ category,” he said.

S&P’s downgrade of Spain to BBB- is illustrative of the trend.

Philp added that credit rating agency action is often a lagging indicator. Rising costs of insuring government bonds in the Credit Default Swap market and increases in the haircuts applied to bonds as collateral for repo or derivatives reduce their attractiveness as collateral and erode at least one source of demand, driving yields higher.

“Specifically in the context of collateral, we do see a real risk of a collateral shortfall, as demand for ‘safe assets’ is given a further boost by the requirement for OTC derivatives transactions to be cleared through central counterparties,” he said.

Estimates of the incremental collateral required to meet stringent initial margin demanded to support cleared and bilateral trades range from hundreds of billions to a few trillions of US dollars. A recent report by TABB Group suggested a figure of $2.6trillion.

Fiscal cliffs and imbalances notwithstanding, AAA/AA government bonds will remain the predominant class of non-cash collateral for the foreseeable future. Mandates and eligibility criteria will be adjusted to accommodate the largest issuers in the absence of viable alternatives.

“Derivatives users that are not natural holders of cash or government bonds will look to transform their non-eligible assets in the repo and securities lending markets in order to participate in cleared derivatives markets. Some governments will undoubtedly drop out of the ‘safe asset’ club, but this will simply increase demand further for those that remain,” Philp said.