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Repercussions of the S&P U.S. Credit Rating Downgrade for OTC Market Participants

Insight Robin Powers Robin Powers · August 11, 2011

On August 5, Standard & Poor’s (S&P) announced that it downgraded the United States to a AA+ rating from its longstanding AAA status. The immediate effects of S&P's downgrade are likely to be modest, largely because it was expected and at least partly discounted in advance. But for participants in the derivatives markets, the downgrade is another source of potential stress on top of the unknowns under Dodd-Frank.

US Treasuries are primary sources of collateral for the swaps and derivatives (listed and OTC) markets, and we expect to see margin requirements increase over time. If market participants start demanding more Treasuries to collateralize the same exposure, investors (both sell side and buy side) could be forced to sell assets to come up with extra collateral, causing broader market declines. For the time being, however, Treasury yields remain lows and so that risk may be more theoretical than real. Clearinghouses that were downgraded in an automatic trigger response to the US’ rating being cut by S&P to AA+ say they have no current plans to make changes to their haircuts on collateral due to the downgrade. For now, the buy side participants in the OTC markets who generally post cash collateral are not likely to be directly affected by a revaluation of Treasuries, but will be affected if there is an overall market tightening.

The repo market saw a shift between the credit rating downgrade decision and market activity on Monday, increasing 0.06 percent.  So while there may be some initial pressure on the repo market, US Treasury securities are still considered the most liquid and safest investments in the world. As a result, collateralized transactions in the money markets backed by US Treasuries will likely remain stable over the near term.  So far, repo market lenders do not appear to be taking any extra safety precautions where collateral is concerned, but when more Treasuries are required to support smaller cash amounts, the repo market could freeze up.

Because of the unprecedented nature of the downgrade of U.S. government obligations, the ultimate impacts on global markets and US financial markets and liquidity are unpredictable and may not be immediately apparent.