Cracks in the Collateral Casino
Swap spreads just flipped upside down, dealers are hoarding Treasuries, and trust is vanishing fast. Is the $2 quadrillion derivatives beast about to bite?
“A system built on leverage can withstand many things…except a sudden demand for cash.” -Someone who understands how liquidity actually works
If a system the size of a small galaxy starts to buckle, you’d think someone might notice.
But here we are…swimming in a derivatives ocean that might be one or two quadrillion dollars deep (nobody knows for sure, not even the lifeguards), and the surface just started rippling in a very, very concerning way.
Now, if you're reading this on some Wall Street terminal between caffeine injections, you’ve likely come across the recent flurry over negative interest rate swap spreads.
Sounds like financial gobbledygook, right? But hang tight.
Because if you follow the neon signs, they’ll lead you straight into the belly of the global monetary system… and it’s looking more like a haunted house than a bank vault.
Let’s cut through the fog.
What in the Swap Is Going On?
Interest rate swap spreads measure the difference between the fixed rate on an interest rate swap and the yield on a Treasury bond of equal maturity…usually the 10-year.
In a normal world (you know, one that existed before central bankers decided they were omnipotent), that spread is positive. Treasuries are the safest of the safe.
Like grandma’s cookie tin: you’re not going to get rich, but you’ll sleep soundly.
But lately? Those spreads have turned negative. And not by a hair. We’re talking negative 30 basis points. That’s not a hiccup. That’s a heart murmur.
Enter the Bank for International Settlements (BIS)…the central bank for central banks.
In a recent report, the BIS tried to tell us this is all just a sign of dealers demanding a "premium" to hold more Treasuries.
Too much supply, not enough appetite, they say.
Think of it like financial indigestion.
To which we say: pull the other one, it’s got bells on it.
Dealers Ain’t Dummies
Let’s break it down like you’re sitting at Denny’s with a napkin and a pen.
Suppose a dealer can enter a swap where they pay a fixed 10% and receive floating at 8%.
Then they borrow $1 billion in the repo market and use that to buy Treasuries yielding 11%.
They pocket the spread. No risk. No capital outlay. No-brainer.
“Wait,” you ask, “what if the repo rate spikes?” Doesn’t matter.
The floating rate they’re receiving is tied to the repo rate (via SOFR), so everything moves in lockstep.
What they pay and what they receive adjust together. They’re essentially locking in a 1% risk-free spread for 10 years.
So… why aren’t they doing it?
The BIS wants you to believe it’s because regulations like the Supplementary Leverage Ratio (SLR) or G-SIB buffers are making balance sheet expansion too costly.
That holding Treasuries is suddenly such a drag on profits that the arbitrage isn't worth it.
But here’s the rub: these rules have been around for years.
The swap spreads were positive in 2016. Post-GFC, post-Dodd-Frank, post-Basel III.
If these regs were the culprit, spreads should’ve gone negative a long time ago and stayed there. But they didn’t. They’ve bounced around like a toddler on a sugar high.
If you’re looking for evidence that the BIS explanation doesn’t pass the sniff test, try this on: swap spreads weren’t deeply negative in 2022 or 2023…even when Treasury issuance was going vertical.
That alone shreds the BIS narrative like a wet tissue.
Something Stinks—And It Ain’t the Regulations
Let’s take off the econometric blinders and apply what I like to call common sense economics.
Dealers aren’t staying away from Treasuries because they’re over-regulated monks afraid of capital charges.
They’re staying away because something’s up. Something big.
Here’s what they are doing: hoarding.
Treasuries are the best collateral in the system.
In good times, one Treasury can be re-hypothecated…used again and again…like a game of financial hot potato.
Ten balance sheets, no problem.
But in bad times? Everyone clutches collateral like it’s toilet paper in a pandemic.
If risk is rising…and believe me, it is…dealers start treating those Treasuries like golden tickets.
Not because they’re afraid of holding them. But because they know the day is coming when the collateral won’t be freely available.
And on that day, they’ll be the ones lending at sky-high spreads.
Which means they’re not avoiding Treasuries. They’re strategically stockpiling them.
The Counterparty’s Perspective
But it takes two to tango in a swap.
For every dealer receiving floating, there’s a counterparty paying it.
Why would anyone willingly pay a floating rate and receive a fixed one when that fixed rate is lower than Treasuries?
Simple. They think rates are going down.
These counterparties are betting that over the next 10 years, the Fed will slash rates.
If the floating rate drops from 8% to 5%, they’re sitting pretty. That’s a 5% spread on top of the 2% fixed they’re getting.
They’re not betting on growth or inflation…they’re betting on collapse.
Which brings us to the real kicker: the entire derivatives market…again, one or two quadrillion dollars deep…is ultimately built on trust. On the assumption that counterparties will pay up. That they’ll exist long enough to make good.
If dealers are passing on risk-free trades, it's not because they're afraid of regs. It’s because they’re afraid you won’t pay them back.
That’s not a technical issue. That’s a systemic one.
The BIS's Comedy Routine
If this sounds like a contradiction in the BIS’s logic, it’s because it is.
They want us to believe Treasury issuance is overwhelming the market. But they also say the lack of issuance is behind the inverted yield curve.
Which is it, gentlemen?
Let’s do a quick fact-check.
In 2023, the U.S. Treasury issued $2.697 trillion in net marketable debt.
In 2024, another $2.520 trillion.
FY2025 Estimate? $2.3 trillion.
And yet, after a brief spike, the 10-year yield dropped 100 basis points. If the market was choking on debt, yields wouldn’t fall…they’d shoot to the moon.
What we’re seeing isn’t a supply problem. It’s a confidence problem. And that’s the kind that blows up markets, not spreadsheets.
When the Tide Goes Out
Let’s zoom out.
The BIS narrative is that dealers are passive drones constrained by rulebooks and leverage caps.
But if you’ve spent more than five minutes on a trading floor, you know that’s laughable.
Dealers are entrepreneurs.
If there’s a way to arbitrage a system, they’ll find it. If there’s profit to be made, they’ll bend the rules until they squeak.
Exhibit A: reserve requirements. The Fed said banks needed 10% reserves. But in 2007, $7.5 trillion in M2 was backed by $40 billion in reserves. Do the math.
The rules didn’t matter then, and they don’t matter now.
What matters is incentive. And the incentive to avoid certain counterparties is screaming louder than swap spreads.
The Derivatives Market Is Whispering… Then Shouting
We are not looking at a quirk. We are not looking at a glitch. This isn’t about some minor tweak in G-SIB buffers or an uptick in Treasury auctions.
This is about risk. Systemic risk.
The market is telling you…loud and clear…that trust is eroding. That counterparties might not pay. That collateral is becoming king. And that when the next crisis hits, everyone will want the same thing at the same time.
Which brings us to the final question: what happens when $2 quadrillion in promises meet a world with $2 trillion in good collateral?
That’s not a question the BIS can answer. But you better believe the dealers are already gaming it out.
Until Then, Stay Rebellious
If the smartest guys in the room are hoarding collateral, avoiding even “risk-free” trades, and bracing for counterparty implosions, maybe we should pay attention.
The system isn’t cracking because of regulations. It’s cracking because it’s built on a mountain of promises… and the wind just picked up.
Until next time, Rebel Capitalists…press your collar stays, polish your common sense, and keep your eye on the repo window. And please…share this article.