27 Apr 2012, Matt Cameron, Risk magazine
Sovereign clients have always been very clear about how they want to trade derivatives: they don’t expect to post collateral, but they might want it from their bank counterparties when trades go in their favour. There has been a big push to preserve this status quo – in Europe, for example, sovereign exemptions appear in mandatory clearing requirements, which would otherwise require them to post initial and variation margin on cleared trades, and in proposals requiring dealers to collect collateral on uncleared trades.
But there are exceptions to every rule, and some sovereign clients are now considering posting collateral on bilateral over-the-counter trades. The Cypriot, Danish and Latvian debt offices are all studying the issue, potentially bringing them in line with those already posting collateral: Hungary, Ireland, Portugal and Sweden. Meanwhile, the European Central Bank (ECB) is understood to be considering the merits of central clearing, and sent out a request for proposal to several banks offering client clearing in the third quarter of last year, according to three sources. That’s despite the fact it campaigned for an exemption from mandatory clearing requirements in the European Market Infrastructure Regulation (Emir).
For the most part, the main driving force for these sovereigns is higher costs – or anticipation of higher costs – on uncollateralised swap transactions. There are various factors causing this, but one of the most important is the realisation that the one-way credit support annex (CSA) favoured by sovereigns creates a huge funding burden for dealers.
These agreements require the dealer to post collateral when the market value of a trade is in the sovereign’s favour, but do not require the client to reciprocate when the situation is reversed. This poses real problems for any bank that has hedged with another dealer or has put the hedge through a clearing house – it would not receive any collateral when the original trade is in its favour, but would still have to post collateral on the offsetting position.
This may not have mattered so much pre-crisis, when funding was cheap and plentiful, but it’s a completely different story today – and the exposure is substantial. The total size of the funding obligation was $29 billion for five banks that provided figures to Risk in February last year (Risk February 2011, pages 18–22). A more recent survey, published last December by the International Swaps and Derivatives Association, Association for Financial Markets in Europe (Afme) and International Capital Market Association (ICMA), estimated dealer exposure to European sovereigns could total around $70 billion.
“Having one-way CSAs can act as a severe funding strain on dealers, because your hedge to that trade will almost always be with an interbank counterparty, and this will be subject to a two-way CSA or will be cleared. You effectively have to fund the mark-to-market of your client when you are in-the-money on the trade,” says Nitin Gulabani, global head of foreign exchange, rates and credit at Standard Chartered in Singapore, and an Isda board member.
There are other implications arising from the refusal of sovereign clients to post collateral. In particular, banks will be required to comply with the credit value adjustment (CVA) capital charge under Basel III from 2013. A key input in the CVA capital calculation is the exposure to a counterparty – and, without collateral acting as a mitigant, the charge could be significantly higher than it would be on a trade backed by a two-way CSA.
In the absence of collateral, the only way a bank can hedge the capital charge is through the credit default swap (CDS) market. However, this creates issues of its own. Specifically, dealers warn it could create a negative feedback loop between CVA and CDS spreads – an increase in CVA would encourage dealers to buy more CDS protection, which could help push spreads wider, in turn increasing the CVA.
Banks already hedge their CVA exposures, so that dynamic exists to some extent at the moment, but dealers argue the new capital charge will increase demand for protection. There are also differences between current hedging practices and the CVA capital rules. Banks typically hedge CVA using a combination of credit and market risk hedges. However, market risk hedges are not recognised under the Basel III CVA rules – in fact, these positions would attract capital of their own.
That means any shift in interest rates or foreign exchange that results in the market value of the trade improving for the dealer – thereby increasing its CVA exposure – can only be mitigated by buying more CDS protection. What is more, sovereign clients tend to use derivatives in similar ways – to swap fixed rate into floating – meaning dealers tend to be positioned the same way, and could end up rushing to buy protection at the same time in response to a market move. That wouldn’t matter if the sovereign CDS market was liquid enough to absorb this demand – unfortunately, it isn’t. According to the Isda/Afme/ICMA paper, if dealers were to hedge their European sovereign exposures through the single-name CDS market, it could require as much as 50% of the entire open interest.
In theory, the ability to hedge through the CDS market means sovereign clients will not see the entire capital charge passed on to them, but they may be required to compensate the dealer for the cost of the CDS hedge – and European sovereign spreads have widened significantly since the onset of the eurozone sovereign debt crisis. If there are not enough sellers of protection to meet the demand for CVA hedges, these spreads could be pushed wider still, dealers say (Risk November 2011, pages 17–20).
Ultimately, the impact of the CVA capital charge on sovereigns may not be as severe as many predict – at least not in Europe. In a recent version of the fourth Capital Requirements Directive (CRD IV), drawn up by the Council of the European Union in March, banks are not required to apply the CVA capital charge to trades conducted with European central banks and sovereign debt offices. This comes on top of the sovereign exemption from the mandatory clearing obligation and margin requirements for uncleared swaps under Emir.
The CVA exemption is not definite – it still has to be approved by the council, European Parliament and European Commission before it makes it into the final version of CRD IV. As such, some European sovereign debt offices want to see how this pans out before making any changes to their collateral policies.
Preparing for two-way CSAs
But even if there is an exemption from the CVA capital charge, it doesn’t mean banks will stop hedging CVA exposures entirely – meaning hedging costs will filter through. The funding burden that exists through one-way CSA exposures will also remain, and these costs may well be passed on. As a result, several sovereign debt offices are making preparatory steps towards two-way CSAs now.
For instance, the Danish central bank, Danmarks Nationalbank, published a report in February confirming the costs of trading under a one-way CSA had risen since the financial crisis. This prompted its debt management arm to begin a study on the cost implications of moving to two-way collateral posting. It plans to publish its analysis by the end of the year.
“We are currently analysing bilateral collateralisation because we are well aware of the capital implications and liquidity obligations that our banking counterparts are facing with regard to one-way CSAs, and how these issues are likely to affect the cost of transacting swaps,” says Ove Sten Jensen, head of the government debt management department at Danmarks Nationalbank in Copenhagen.
According to a report by the Organisation for Economic Co-operation and Development (OECD) in November, just three sovereign debt management offices use two-way CSAs exclusively – although a few more use them alongside one-way agreements. That compares with 16 that only use one-way CSAs (see table A).
Two of those using two-way CSAs have adopted them over the past two years. Portugal’s Instituto de Gestão da Tesouraria e do Crédito Público made the change in July 2010 amid expectations that prices would increase for swaps under one-way CSAs (Risk August 2010, pages 24–26). The most recent conversion is Ireland’s National Treasury Management Agency (NTMA), which announced it had started posting collateral last year (Risk September 2011, page 8). Dealers say the NTMA’s hand was forced, as banks were reluctant to trade with it on an uncollateralised basis as the country moved closer to a European Union (EU)-International Monetary Fund bail-out.
This list is expected to grow, with the Latvian and Cypriot debt offices conducting similar analysis to Denmark. However, the speed of the conversion will depend on whether banks are passing on the full cost of the funding obligation and CVA hedge. The large dealers say they are incorporating these elements into their pricing now, but acknowledge these costs might be waived to win prestigious sovereign clients.
“The pressure to post collateral is definitely being applied to sovereigns, but the outcome of this pressure will depend on whether banks are actually reflecting the true costs in the price of the swap. Theoretically, the cost should be shared between the dealer and the client, but the split may differ between banks and counterparties,” says Gulabani at Standard Chartered.
Others agree, noting this can make it difficult for banks that are taking all these factors into account to compete. “There are still a number of banks not pricing in the true funding obligations on long-dated swaps with sovereigns, and this makes it tricky for banks that are pricing in the correct funding costs to compete. While only a small subset of banks is mispricing these trades, it’s still a problem that needs to be rectified,” says Tong Lee, global head of rates at UniCredit in London.
Beyond pricing, there are other issues that may delay the switch to two-way collateral posting. The Latvian debt management office, for instance, has asked Eurostat, the statistical office of the EU, whether the posting of collateral would have any impact on its debt levels.
“We have spoken to a number of our counterparties, and we know there are incentives for them to sign two-way CSAs. We have asked for differences in prices between uncollateralised swaps and trades that are bilaterally collateralised, and we found it would generally improve the pricing of the swap and the treatment would be more favourable. But it is not as straightforward as that. We have also made enquiries with Eurostat about how the posting and receiving of collateral would affect our liabilities. So we’re looking to cover all the bases before we make a decision,” says Girts Helmanis, director in the financial resources department at the Treasury of the Republic of Latvia in Riga.
As it stands, cash collateral posted to debt offices and other sovereign entities against derivatives counterparty exposures is technically required to be reported as a loan and included in each country’s debt statistics (Risk March 2011, page 26–28). The same applies if the sovereign had to raise funds in order to meet a collateral call – the debt statistics for the country would increase by that amount.
Others are also concerned about this point – the Cypriot Public Debt Management Office (PDMO), for example, acknowledges it may sign two-way CSAs, but is looking at how it will affect debt levels.
“We are infrequent users of swaps and have only transacted with local banks on an uncollateralised basis so far. But we are exploring the possibility of expanding our list of counterparties to include other European banks and, if we decide to do that, we anticipate having to sign two-way collateral agreements. So we will be examining exactly how posting and receiving collateral is treated from a public debt perspective,” says Phaedon Kalozois, director of finance and the head of the PDMO at the Cypriot Ministry of Finance in Nicosia.
Central counterparty clearing
Signing a two-way CSA is one way to avoid having funding and capital costs passed on by dealers. The other is to clear derivatives through central counterparties (CCPs). According to the OECD report, just one sovereign debt manager is using a CCP for interest rate swaps – believed to be the Riksgälden, the Swedish debt management office (Risk March 2011, page 9). Given the exemption written into Emir, others won’t be forced to follow suit, but some debt managers and central banks think it is a good idea.
“We already have two-way CSAs, and we are currently gathering information about central clearing and figuring out whether market forces are going to take us down this road. We are talking with our counterparties but, as yet, we haven’t felt compelled to decide to centrally clear, and we’re not sure how it would all work. But if, in theory, we were to centrally clear, it would actually benefit us from an operational perspective because we are currently having to deal with multiple collateral flows every day. Whereas, if we used one or two clearing members or joined a CCP directly, we would only have one or two collateral flows,” says Ondrej Stradal, head of foreign exchange reserves management at the Česká Národní Banka, the Czech national bank in Prague.
The ECB published a paper last November that outlines five standards for central banks that want to access central clearing, and is understood to have set up an internal working group to look into the issue, but declined to comment.
Ultimately, it comes down to costs. If banks pass the funding and capital charges on to sovereign clients, more will likely consider a change to central clearing or two-way collateralisation. As long as banks are willing to absorb these costs to win business, however, there is little incentive to change.