Central banks accused of collateral hypocrisy

Despite the funding risk it creates, central banks still refuse to sign two-way collateral agreements

Dealers are railing against central banks for what they see as hypocrisy – while policy-makers call for wider use of collateral in derivatives markets or push participants towards the use of central counterparties (CCPs), central bank dealing desks refuse to post collateral themselves and have also negotiated an exemption from incoming European clearing rules. It's a policy dealers claim is exposing the industry to huge funding costs and risks.

"If you go back to the financial crisis, what immediately happened was a liquidity squeeze for the big swap houses, and the sovereigns are one of the biggest drains on liquidity because they're not posting collateral on their derivatives. So they're making the problem worse, while simultaneously forcing everyone else into central counterparties with zero posting thresholds – it's hugely hypocritical," says a London-based rates trader at one US bank.

Others use more colourful language – absurd, illogical, schizophrenic. Feelings are running high because of the numbers involved. Banks individually have multiple billions of volatile funding requirements arising from trades with sovereign, supranational and agency (SSA) clients – and they expect those requirements to jump as rates rise.

The problem arises because SSAs tend to have one-way credit support annexes (CSAs), meaning the sovereign will receive – but not post – collateral, but banks hedge these trades in the interdealer market under two-way CSAs, which require collateral posting by both counterparties. So, when the original trade is in the SSA's favour, the dealer will have to post collateral but will also be receiving collateral from its counterparty in the offsetting hedging trade. When the value of the SSA trade reverses, the dealer will have to post collateral to its hedge counterparty but won't be receiving any from the SSA, creating a funding risk if markets move far enough and fast enough. That's a source of market instability that central banks should care about, dealers claim.

"Does a supranational care about the orderly functioning of markets? Yes, to the extent that it needs to borrow money, but it's not the organisation responsible for the orderly functioning of markets – the Bank of England is. And the Bank of England also has collateral agreements that are extremely difficult for banks to cope with. And I've seen no movement – absolutely no movement – among the stronger sovereigns, the stronger central banks, towards two-way CSAs at all," says the head of the SSA desk at one European bank.

Does a supranational care about the orderly functioning of markets? Yes - but it's not the organisation responsible for the orderly functioning of markets - the Bank of England is

"It's an Alice in Wonderland kind of scenario," says a London-based treasury source at one European bank. "You've got the financial stability people telling banks to get their house in order when it comes to funding and liquidity. And then you've got the markets division of the same organisation refusing to post collateral and – in some cases – making matters worse by creating additional funding requirements."

The Banque de France is a case in point, dealers say. Its June 2010 financial stability report included an article from the bank's governor Christian Noyer, which described how derivatives markets should be redesigned to ensure financial stability. In it, Noyer calls for collateral posting to be "enhanced and harmonised as highly rated counterparties and most corporations are not required to post margins by their counterparties".

Apparently, that doesn't apply to the central bank. Dealers say it has recently begun asking them to post collateral under a one-way CSA for the first time – a step that serves to worsen the funding position for its counterparties because there was previously no collateral being posted by either side.

In addition, despite enthusiastically supporting proposals that would require other derivatives users to use CCPs – resulting in both parties to a trade posting collateral – the French central bank's response to a European Commission consultation on the topic last July called for all central banks to be "excluded from the scope of the future legislation on market infrastructures and, in particular, from the clearing obligation". The resulting proposals include an explicit exemption for central banks, debt offices and other state-backed issuers.

The Bank of England has made similar calls for collateral to be used more widely, but is also said to use one-way CSAs with its dealers. Officials at the central bank declined to comment, and a spokesperson would not confirm the details of its collateral agreements.

All of this could change – and will change, dealers insist. The head of rates at one US bank claims central banks are well aware that their position is untenable, but it will take time for them to move. When they do shift, they might do so as a group rather than individually, he says. "There's a conversation a number of European central banks are having about a multilateral move. But I think that has 12–18 months to run before any action will happen. They're kind of trapped because they know it's systemically risk-increasing to have one-way CSAs – they know there's no logical excuse for them when they're saying everyone else would be better off with two-way agreements, but they feel unable to make the move on their own."

And some central bankers say as much themselves. "I recognise the argument and I would wonder how sustainable it is from a long-term perspective," says a senior figure at one Group of Seven central bank.

Another admits the community has a credibility issue to address. "Walking the talk is part of the problem. It's going to be hard for the public sector, with all of these types of agencies, to continue the practice of not having two-way posting if at the same time we're regulating liquidity and counterparty risk more tightly," says one central bank economist.