For many, many, many purposes in financial markets, you have to post collateral. Most importantly, if you want to borrow money in some of the biggest lending markets, you put up some collateral and get the money; when you repay the money you get the collateral back. If you do certain derivatives trades, you have to post collateral to ensure that you are good for your obligations. If you want to sell a stock short, you borrow the stock and post collateral to secure your obligation to return it. If you are a retail brokerage, your customers do trades today but actually hand over the money on Friday, and meanwhile you post collateral with a clearinghouse to guarantee their trades. The plumbing of global finance works through collateral: You and I can agree to do stuff in the future, without necessarily knowing each other well or trusting each other much, because we have posted collateral to ensure that we’re good for our promises.
Often the way this works is that the collateral consists of some securities that you own, and the safer the securities are — the more likely they are to retain their value — the better they are as collateral. The best collateral, for most things in US finance, is short-term US Treasury bills, which have no credit risk and very little interest-rate risk and are pretty much always worth a pretty predictable amount. Longer-term Treasury bonds are also good, though they have more rate risk. Some other kinds of collateral — agency bonds, municipal bonds, highly rated corporate and structured-finance bonds, etc. — are also quite good and acceptable for many purposes, though not all; some sorts of collateral-demanding businesses are very picky and will accept only Treasuries. And then there is a lot of other stuff: Junk bonds, penny stocks, private-company stocks, fractional ownership of racehorses, any sort of financial asset you can name. So much crypto. All of this stuff could be collateral, for some purposes; somebody would probably lend you money against any of it. But if you bring it to the GCF repo market or the Fed’s discount window they will turn up their noses; they don’t take fractional racehorses there.
The point of the collateral, in a lot of the big markets, is to make things easy and efficient, so nobody has to think about risk. Somebody will lend you money against a fractional racehorse or your startup shares, but they will think about it for a while and make a particular underwriting decision; they will be in the specialized business of lending money against weird assets. Financial-markets plumbing is different; it is a big organized system that uses fungible collateral that everybody agrees is good and that nobody has to think about specifically. Huge piles of similar, safe assets — like the trillions of dollars of reliable and well-understood US Treasuries — work best; weird bespoke stuff doesn’t work at all.
And of course if you have some bonds that are in default, where the issuer is not current on its interest and principal payments, they would be quite bad collateral. Not that they’re worthless, necessarily — maybe the issuer will get its act together and start paying again — just that evaluating defaulted debt is a very specific skill. Many systems that demand collateral would not even consider defaulted bonds as collateral; defaulted bonds are not at all the sort of safe, fungible assets that work as collateral in deep and liquid markets
And so of course the question is, if Treasury bills are also defaulted bonds, what happens? Does everything break?
I want to make a couple of points here: