By Vidya Ranganathan
SINGAPORE, Oct 11 (Reuters) - Some financial institutions are reducing the use of U.S. Treasury bills as collateral for transactions in stocks and swaps as they prepare for the possibility of a U.S. government default.
Hong Kong's securities exchanges announced on Thursday they will apply a bigger discount on the U.S. Treasuries used as margin collateral.
Traders and risk officers at banks said they were carefully monitoring portfolios and collateral, with some putting contingency plans in place to deal with default or a sudden loss of liquidity in the securities, the world's most risk-free assets after cash.
"Maintaining liquidity is a primary focus of contingency plans set up to deal with a default," said a trader at an American bank in Tokyo. Shorter-maturity Treasury securities would no longer be accepted as collateral if the United States defaulted on its debt, he said.
"Many repo agreements are being amended to exclude these types of instruments in order to ensure liquidity is maintained," he said.
Traders expect the $5 trillion U.S. repo market, used to fund short-term borrowings against government securities, to be the worst hit if the United States defaulted.
Even if markets believed that the U.S. government will eventually meet its debt obligations, a temporary delay in payments would be construed as default, and financial markets do not trade or lend against defaulted securities.
The fiscal standoff in Washington is in its third week. Most government services have been shut down since Oct. 1, when lawmakers failed to agree on funding them.
President Barack Obama and Republican leaders were in talks late on Thursday to try to reopen government and extend its borrowing authority beyond Oct. 17.
Failing that, the government will hit its $16.7 trillion borrowing limit and could potentially default on social security or Treasury payments late in October or early next month.
The Hong Kong Exchanges & Clearing (HKEx) said it will apply a haircut of 3 percent versus the current 1 percent for treasury bills with a maturity of less than a year that are used as collateral to meet margin requirements.
Haircuts applied to longer-dated bills remain unchanged. HKEx is the holding company for The Stock Exchange of Hong Kong Ltd, Hong Kong Futures Exchange Ltd and Hong Kong Securities Clearing Company Ltd.
"Participants should make necessary funding arrangements to cover any shortfall to their margin requirements resulting from the increase in the U.S. Treasuries haircut," HKEx said.
Exchanges elsewhere in Asia have not so far disclosed any plans to deal with a U.S. debt default.
"We are monitoring, but I don't think things will get to a point where some kind of an emergency plan has to be activated," said Seo Sang-joon, market conditions team manager for the Korea Exchange. Seo said Treasuries were not commonly used in Korea as collateral.
The Japan Securities Clearing Corp, whose clients include the Tokyo Stock Exchange, was reviewing procedures, said Katsuya Sakaba, head of its Risk Management Division.
"As a rule, if there is a default, we will revise collateral haircuts. We'll apply a more conservative haircut rate, or raise the rate, although that's never happened, not even two years ago," he said, referring to a similar U.S. political showdown over debt in 2011.
A U.S. default could kick up a storm in financial markets and a massive rush into risk-free assets.
But, in some ways, that risk is a bigger headache for regulators and market participants than exchanges in Asia, most of which use cash as collateral.
Equities are exchange-traded, but there is no mandatory requirement in Asia for currency and interest rate swaps to be cleared through an exchange as they are in the United States and parts of Europe.
For most over-the-counter swaps and other derivatives traded in Asia, collateral is posted directly between the two parties to a deal.
Most deals use cash as collateral, rather than Treasuries, said Singapore-based Sam Ahmed, head of collateral services sales at Citi in Asia.
"For now we are just tracking and stress-testing client portfolios that hold short-dated Treasuries with November and December maturities," Ahmed said.
The risk that the margin collateral posted on transactions loses value rapidly, and thereby undermines the protection against default, is higher for stock and securities exchanges than for individual banks or traders, said a risk officer at an Asian bank in Singapore.
"These exchanges are multilateral, and stand between several counterparties at the same time," he said. "They are stuffed if they get it wrong."