For a few dollars more: Japan banks tackle dollar/yen basis jump

The dollar/yen cross-currency basis has widened nearly 50% in recent months due to a surge in demand from Japanese banks and regulatory constraints curbing supply from US dealers. With trading costs soaring, Japanese banks are turning to more exotic solutions to get their hands on US dollars

Since Japan's infamous 'lost decade' of the 1990s, the country's financial landscape has often come to resemble the bleak vision of Sergio Leone western movies, with institutions clinging on for survival in an unforgiving environment. Japan's banks, like a posse of gunslingers, have been hunting down the riches of higher-yielding assets in the form of dollar-denominated investments.

But these dollars have proved increasingly hard to come by as a combination of surging demand for cross-currency swaps and regulatory initiatives such as the leverage ratio has started to bite big US dealers – the main source of US dollar funding. All of which has meant banks in Japan now face millions of dollars in extra trading costs, through a widening of the so-called dollar/yen cross-currency basis, particularly at longer maturities. With Japanese yields sitting at rock bottom levels in recent years, domestic banks had stocked up on US dollar-denominated assets to generate higher returns.

"Dollar funding is a big headache for Japanese banks after the cross-currency basis market widened. Capital is hitting everyone on the Street, so the credit lines available from broker-dealers are getting smaller and smaller," says Shintaro Isono, head of the derivatives structuring group at Goldman Sachs in Tokyo.

The cross-currency swap market became the dominant way for large Japanese banks to access US dollar funding to buy these assets directly, or to lend to other regional banks to do the same. The cross-currency basis compensates a dealer for country and liquidity risk, and can be a big component of the value of a cross-currency swap. The basis is either added or subtracted from the interest rate paid by the non-dealer counterparty.

The dollar/yen basis has been negative since 2007, which reduces the interest rate Japanese banks receive on the swap. Given the swaps are usually matched to interest rates on their deposit liabilities, it forces the banks to fund the difference themselves.

While the cross-currency basis has often been negative in the past (see box, Negative basis is here to stay), market participants say a combination of recent events has led to a near 50% widening since the start of the year, costing banks millions of dollars.

Many blame the US supplementary leverage ratio (SLR), which requires US global systemically important banks (G-Sibs) to hold capital against at least 5% of leverage exposures, and 6% for federally insured subsidiaries. Cross-currency swaps are treated harshly in the leverage calculation, and the typical collateral posted can't be used to reduce the exposures.

The widening negative basis in Japan is part of a broader trend that is dislocating swap markets across the globe. In early November, US interest rate swap spreads moved below bond yields, which market participants put down to higher capital requirements and reduced dealer balance sheet availability.

Demand for US dollars is also expected to increase when the US raises its interest rates, as Japanese banks join pension funds and insurers in a race to buy higher-yielding US assets – a move likely to push the basis wider still.

Japanese banks have looked at alternative ways to raise dollars as a result. Some have included resettable features in the swaps to shorten the duration, while others have issued dollar-denominated bonds backed with securitised assets.

The QE effect

The issue in Japan stems from the quantitative easing measures implemented by its central bank, which have cut Japanese government bond (JGB) yields to negative at the five-year point, and weakened the yen by 58% since September 2012. This has meant Japanese banks' stockpile of yen cash deposits has been generating lower and lower returns when invested in JGBs.

As a result, Japanese institutions have been hunting out alternative investments in hard currency such as US dollars to generate better returns. Typically, the larger Japanese institutions source US dollar funding from US banks, and invest it in dollar-denominated assets or lend it to their regional peers. Research from Barclays shows the amount of foreign currency loans outstanding among Japanese banks – the majority of which are in US dollars – has doubled from less than $400 billion to nearly $800 billion between 2010 and 2015.

Atsushi Mimoto, head of the business promotion team in the global markets planning department at Sumitomo Mitsui Trust Bank (SMTB) in Tokyo, says the bank has ramped up its dollar-denominated lending activities.

"We are increasing foreign assets just like the megabanks in Japan, as yields for onshore assets are very low. We are mainly offering dollar loans to Japanese and non-Japanese companies," says Mimoto.

Dollar-denominated bond issuances and deposit taking have been the traditional routes for Japanese banks to obtain the currency, with the cross-currency repo and swap markets seen as a secondary route. Banks, however, have limits on the amount of debt they can issue in foreign currencies, and only the biggest Japanese banks have entities in the US that can easily receive dollar deposits. The downgrade of Japan's sovereign rating to AA- by Standard & Poor's in September also made this route more expensive.

Given the outsized demand for dollars from Japanese banks, the cross-currency repo and swap markets have had to pick up the slack. However, the repo markets have been under stress from regulatory changes.

Banks offering repo services have to hold capital against the leverage exposure generated by the trades – no matter how risky the position – while netting is limited. The slim margins in the repo market make it difficult to earn enough return on equity on the capital allocated to cover the leverage exposure of these repo trades, affecting liquidity in the process.

This is set to get worse when the Basel Committee on Banking Supervision's net stable funding ratio (NSFR) – the second of its key liquidity ratios – comes into force in 2018. The NSFR requires banks to hold 10% of long-term funding against the value of a reverse repo with a financial institution, even if the funding is offset with another repo trade.

As a result, Japanese banks have turned to cross-currency swaps to secure dollar funding. According to figures from Japan's Financial Services Agency, domestic banks had ¥112 trillion ($910 billion) of gross notional cross-currency swaps outstanding as of June 2015, up 7.5% from June 2014.

The trade sees Japanese banks swap the notional amount of their yen deposit funding for US dollars up front, then paying US dollar Libor and receiving yen Libor, minus the cross-currency basis spread, for the life of the trade. The two counterparties then re-exchange the principal amounts at the end of the trade, at the initial foreign exchange rate.

Following the rules

But while demand for dollar/yen cross-currency swaps has risen, US banks have found it increasingly difficult to put the trades on. Regulation is the main culprit, especially the SLR, which treats the instrument especially harshly.

The leverage exposure of a swap consists of two parts: the mark-to-market exposure, and the potential future exposure (PFE). The mark-to-market of cross-currency swaps can be larger than that of regular interest rate swaps as they are sensitive to the interest and forex rates, which can inflate leverage exposures. Banks, however, usually post JGBs as variation margin, which can't be used to net down these exposures under the leverage ratio rules.

In addition, the PFE calculation – designed to capture future changes in derivatives exposure – includes a conversion factor applied to the notional amount that is also unkind to the instrument. Cross-currency swaps are treated as a forex product, which has a higher conversion rate than regular interest rate swaps; for instance, for a swap longer than five years, the conversion rate for interest rate swaps is 0.015, while for a cross-currency swap it is 0.075.

These effects create larger leverage exposures that need to be capitalised, meaning banks are more wary of entering into cross-currency swaps. This became a real issue at the start of the year, when US banks started publishing their leverage ratios, which are watched closely by investors and analysts.

"We had to start reporting leverage ratio numbers on our balance sheet from January, and people are getting more concerned about disclosure. If we publish just 4.5%, then the market will see we are behind, so we have to err on the side of caution when offering products such as dollar/yen cross-currency swaps," says a senior fixed-income source at a US bank in Asia.

This mix of strong demand and falling supply has helped force the cross-currency basis to widen by nearly 50% since the start of the year. The five-year dollar/yen cross-currency basis was minus 60 basis points on January 1 this year, but hit minus 87bp on November 5.

This means that for a $100 million swap it is now 27bp more expensive to convert yen into dollars in November than it was in January, which equates to $270,000 annually, or $1.35 million over the life of a five-year trade.

"For longer-term funding, cross-currency swaps at three-to-five year tenors are increasing in cost compared to the other routes," says SMTB's Mimoto.

It's not just the leverage ratio causing issues for US banks, however. Cross-currency swap trades can also increase banks' G-Sib score, which determines how much extra capital they have to hold against their risk-weighted assets (RWAs) on top of their regular capital requirements. One-fifth of the overall US G-Sib score comes from the amount of leverage exposures the bank has, calculated using the SLR methodology. Total notional values of over-the-counter derivatives makes up 6.67% of the total score, while the amount of hard-to-value instruments the bank has, known as level three assets, also contributes 6.67% to the G-Sib score.

"Three things increase our G-Sib profile: the size of balance sheet, level three assets and derivatives notionals. So we are more careful with capital-intensive trades," says a senior forex source at a US bank in Asia.

As a result, US banks are more careful about entering into new cross-currency swap trades. "There is a clear trend that banks are focused on their cost base, so it's no longer good enough to have the top line. They are conscious of the RWAs they are spending to do each business," the source says.

Goldman Sachs' Isono agrees, saying the huge focus on return on equity means it's increasingly difficult to enter into cross-currency swaps. "Japanese banks have relied quite heavily on cross-currency basis and repo, but these days we can't do that much as regulation is increasing the cost of balance sheet," he says.

Another issue is the embedded wrong-way risk in the instrument, as Japanese banks tend to post JGBs as collateral, which are correlated with their own credit quality.

"Typically, we do a cross-currency swap by providing dollars and receiving JGBs as collateral, which is wrong-way risk for us, so that also means we don't want to massively increase the size of deals," says Isono.

Samurai worriers

Demand from the samurai bond market has also been blamed for the widening cross-currency basis. Samurai bonds are debt instruments issued in yen by non-Japanese companies and then converted into US dollars via cross-currency swaps. Samurai bond issuance hit a seven-year high in 2014, reaching $24.6 billion, according to figures from Dealogic. This year has been slower, with $13.6 billion of samurai bond issuance up to October, but has still impacted the basis, according to traders.

"A large volume of samurai issuance has caused a widening of the basis. Whenever people need dollar funding against yen, the basis will typically widen to reflect supply and demand," says a senior fixed-income source at a US bank in Asia.

With the market for dollar/yen cross-currency swaps increasingly tricky, banks have looked for alternative solutions. According to the US bank's fixed-income source, one popular product to address the widening basis has been a floating resettable cross-currency swap.

This is similar to a regular cross-currency swap, however the basis is reset every quarter instead of being locked in up front for the life of the trade. This allows Japanese banks to obtain longer-term dollar funding while taking advantage of a more favourable basis at the shorter end of the curve, which is structurally cheaper than longer maturities. At time of press, the three-month dollar/yen basis was minus 60bp, while the five-year basis was minus 87bp.

But while this seems like a clever solution, the fixed-income source admits it won't solve the underlying issue: "From the bank side, there is still a leverage ratio constraint, as it's a cross-currency swap, and we also need to manage cashflows very precisely, which is operationally burdensome. And whenever the short-term forex forward market crashes, it creates more risk for us, so it's by no means perfect," he says.

Other potential solutions have been touted. SMTB's Mimoto says US dealers have encouraged the bank to give up their right to post JGBs as variation margin and instead move on to cash-only credit support annexes (CSAs), as only cash can be used to reduce mark-to-market exposures in the leverage ratio.

"Some banks have asked us to provide cash-only collateral in CSAs with daily margin posting, as this has a reduced effect on their leverage ratio constraint," he says.

Others have looked at issuing covered bond-type instruments to obtain dollar funding. In October, Goldman Sachs created a joint venture with SMTB, where euro- and yen-denominated residential mortgage-backed securities (RMBSs) from both banks were parked into a single vehicle, which issued a $500 million bond to European and US investors.

The bond priced at US dollar Libor plus 90bp, which is only 3bp more expensive than the cross-currency swap. As well as being a relatively cheap way of funding dollars, for SMTB this was a new way to generate funding using unencumbered assets such as RMBSs that are not eligible as collateral for repo or cross-currency swaps. Solutions such as these are likely to become more popular as strategists believe cross-currency swaps will only become more expensive over time.

Akito Fukunaga, chief Japan rates strategist at Barclays in Tokyo, says the cross-currency basis "will go down in the near term, maybe to minus 100bp next year. There needs to be more risk premium for dollar lenders at the moment. The current level isn't fair to lenders compared to their risk appetite, but we may see stabilisation within six months."

Market participants note that an imminent US interest rate hike is likely to push the basis even wider, due to an increase in demand for US dollars. The senior US bank fixed-income source says Japanese banks may reach a point where the yield pick-up from buying dollar assets may not be worth the extra funding costs.

"The funding cost is getting more expensive and the net margin they can earn is getting squeezed, so senior management on the client side is wondering whether to go after more foreign assets. But in the Japanese market, they can't consider domestic investments as there aren't any meaningful opportunities in rates and credit, so they prefer to focus on overseas assets and want to cheapen the funding cost," he says.

With the Bank of Japan still in quantitative easing mode, the medium-term trend implies yields on JGBs will remain low, forcing Japanese banks to continue to look to dollar-denominated assets: "The market has become one-directional, as Japanese investors are likely to do the same thing; it's a Japanese characteristic," says a fixed-income source at a Japanese institution in Tokyo.

Negative basis is here to stay

The cross-currency basis for dollar/yen swaps has been negative at the five-year point since 2007. At that time, risk-averse investors flocked to the world's reserve currency, causing a supply and demand imbalance in the cross-currency basis market.

This was especially notable at shorter tenors, until the US Federal Reserve announced in December 2007 that it had set up US dollar liquidity swap lines with more than a dozen central banks, including the Bank of Japan, to release pressure on short-term dollar funding.

It kept these lines in place until February 2010, but reinstated them three months later. The liquidity lines were made permanent in October 2013.

The swaps have maturities ranging from overnight to three months, which some believe is the reason why the dollar/yen cross-currency basis is significantly smaller at shorter maturities. At time of press, the three-month dollar/yen basis was minus 60 basis points, while the five-year basis was minus 87bp.

The dollar/yen cross-currency basis hit its peak in 2011 during the European sovereign crisis, when it reached minus 100bp in December.

The basis had been negative before 2007; through most of the 1990s, in fact, which reflected the deterioration in the creditworthiness of the Japanese banking system following the bursting of the country's credit bubble.

Some believe the basis is effectively structurally negative now, as Japan is a net external creditor and has foreign exchange hedging demands for dollars that outweigh demand for yen.