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Wall Street’s $4 trillion kitty

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matthewgoldstein.jpgThe Obama administration’s plan for reining in derivatives leaves unchecked one of Wall Street’s dirty little secrets: the ability of a derivatives dealer to redeploy cash collateral that gets posted by one of its trading partners.

On Wall Street, this practice of taking collateral and reusing it is called rehypothecation. In essence, it’s a form of free money for derivatives dealers to use as they please — even to repost it as collateral to finance their parent company’s own borrowings.

And we’re talking big bucks. The International Swaps and Derivatives Association recently reported that derivatives dealers have taken in $4 trillion in collateral from their trading partners. That’s an 86 percent increase over the $2.1 trillion in cash collateral those same dealers reported having on their books in early 2008.

Now it’s not surprising that investment firms took in more collateral from their trading partners over the last year, when the financial markets were in turmoil. Cash collateral is one way for derivatives dealers to protect themselves against the risk of a trading partner defaulting on one of these sophisticated financial contracts.

What’s the Justice Department’s angle on derivatives?

Lots of posts and articles are circulating about the Department of Justice’s investigation into the derivatives market and specifically the dealers that own Markit – the administrator of popular credit default swaps indexes and aggregator of CDS prices.

Yet, I must say I’m not sure what the investigation hopes to turn up. Instead, it looks more like the Obama Administration flexing its muscle to let banks know that it’s serious about derivatives regulation just in case they didn’t get the point when the government released its white paper on regulatory overhaul last month.

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