08 Oct 2012, Michael Watt, Risk magazine
As the clock counts down to December 31 – the deadline set by the Group of 20 (G-20) nations for all standardised over-the-counter derivatives to be centrally cleared – dealers in the world’s financial centres are fretting over margin requirements, client clearing relationships and default fund contributions. Incomplete rules and unfinished preparations mean the world would miss the G-20 deadline but, in the US and Europe, it will be missed by a matter of only months.
In South Africa, the questions are a little more fundamental. For one, where will the clearing house actually be located? Market participants don’t seem to have reached a consensus, according to a survey conducted by Risk South Africa alongside its annual rankings of derivatives dealers – 30% of respondents favour an onshore central counterparty (CCP), 33.6% believe participants should be free to access existing overseas clearers such as LCH.Clearnet’s SwapClear service for interest rate swaps, and 36.4% haven’t decided either way. Only 43.6% of respondents believe OTC clearing should be mandatory in the first place. The regulators don’t seem to have made up their minds on the offshore versus onshore issue either. The latest version of South Africa’s Financial Markets Bill, released in April, does not provide a definite answer.
According to Andrew Hall, head of global markets at Standard Bank in Johannesburg, a decision needs to be reached soon. “We won’t have a local CCP offering in time for the deadline, so we’ll have to clear offshore initially, but the Financial Markets Bill contains enabling provisions for both local and offshore clearing, which is sensible until we decide the correct path for South Africa.”
Obstacles to offshore clearing first need to be hurdled. “South Africa still has exchange control restrictions. If we were to clear our derivatives with LCH.Clearnet in London, and were able to post the rand to that clearing house as variation margin, does that contravene the exchange control ruling? The South African Reserve Bank (SARB) needs to put out a ruling on this issue quickly,” says André Eerenstein, an interest rates derivatives specialist at Rand Merchant Bank in Johannesburg. “If we can’t settle in rand, we’ll have to settle in dollars, but will this take up some of the foreign currency allowance that the regulators let us have on balance sheet? If so, it’s not a particularly efficient use of this allowance, as collateral instruments are generally low-yielding assets, and we’ll have to pay a cost to source the dollar-denominated ones. The pricing of derivatives also becomes more complex because local banks generally have to pay up for US dollar funding relative to the return earned on LCH.Clearnet margin accounts.”
Dealers predict that, if South Africa’s big banks are allowed to clear offshore, it will be difficult to tempt them back to a domestic CCP once one is set up. This raises another question: will South African regulators allow the bulk of the OTC deals made by their systemically important banks to be cleared by an institution beyond their control and regulated by other authorities?
“As a G-20 member, I hope South Africa will be comfortable with the regulatory standards of other members,” says Hall at Standard Bank. This may be a forlorn hope. Several national jurisdictions, such as Australia, Canada, Hong Kong, Japan and Singapore, have seriously considered or actually mandated the use of a local clearing house for some trades. A turf war has already broken out between European regulators over the location of CCPs that clear large amounts of euro-denominated products (Risk January 2012, pages 14–18, www.risk.net/2134744).
The creation of a domestic CCP won’t be plain sailing either. No institution has come up with a viable service so far, but market participants expect the Johannesburg Stock Exchange to step up – it already owns Safcom, the clearing house for the South African Futures Exchange – but it has a number of problems to solve first. For a start, the existing big OTC CCPs all have a default fund as part of their waterfall of financial resources. This is not the model at Safcom, where every clearing member has an unlimited liability for the losses of other member firms that exceed initial margin. The logic behind this is that Safcom’s existing clearing members – essentially the large South African banks – are so systemically important that the authorities will not allow them to fail. Since they are liable for Safcom’s losses to the last rand of their own capital, a default fund would never need to be tapped (www.risk.net/2157918). This solution doesn’t sit happily with the new international clearing standards, and Safcom will probably have to scrap it in favour of a traditional default fund system if it is to find favour as an OTC clearer, dealers say.
South Africa’s banks are co-operating in an industry survey to find the best way to enable OTC clearing, and some would be quite happy to see the Safcom model bite the dust. “The current futures exchange clearing model isn’t too convenient for us, as we’re not comfortable being on the hook as lender of last resort when more and more people start to sign up to an OTC clearing service that may use the same model. If a domestic CCP doesn’t comply with international standards, we don’t get the capital relief from clearing with them, so it rather defeats the point,” says Hall.
South African banks are also grappling with the concept of client clearing – acting as a clearing intermediary for clients without the financial muscle or technological savvy to access CCPs directly. Banks in the US and Europe have thrown huge resources at the problem over the last three years, but are still struggling to make the business viable from both an operational and risk management perspective. For South African banks, it means clients will have to pay more for the privilege of trading in OTC markets.
“The closest we have to a client clearing set-up is our prime broking platform, where clients effectively rent balance sheets from the bank and are margined accordingly,” says Rand Merchant Bank’s Eerenstein. “Clients can trade with other banks and name that platform as the counterpart. We collateralise the trade as part of our broking relationship. The issue is going to be when you take an OTC extension on that. What impact is it going to have on client pricing? What are the prime brokers going to charge clients in order to rent balance sheets given that we will mostly likely be funding their collateral needs in dollars? Bid-offer spreads will probably be wider because the basic cost of a transaction will have to be variable to cope with moves in the US dollar/rand basis market.”
While these issues are in flux, this year’s Risk South Africa Rankings remain in virtual stasis. The top-five dealers all retain the same spots they occupied last year in the overall table. Absa Capital, Standard Bank and Rand Merchant Bank are the top three and have a slight edge over the competition with 21.2%, 20.2% and 19.3% of the total votes, respectively.
“It has certainly been a challenging year. New regulation and a tough global economic environment have ensured that,” says Chris Paizis, head of corporate distribution at Absa Capital in Johannesburg, which earned its overall top spot partly as a result of a strong showing in the foreign exchange and interest rates categories – it came first overall in foreign exchange derivatives and second in rates. “General liquidity shouldn’t be an issue because corporates and banks in South Africa are pretty flush with cash at the moment. However, a lot of participants have become more and more defensive in their trading outlook this year.”
Dealers are looking to both domestic and international issues to explain this drop off in activity. “The year to date has been fairly strong for us, but it’s fair to say that we are seeing a drop off in client activity, particularly where it is related to investment spend. The volatility in the rand certainly helps everyone’s foreign exchange businesses, but other than that it’s becoming fairly quiet. I’d say the cause of this is a combination of the eurozone crisis finally feeding through to South African business and a general hesitancy to make large, long-term investment or hedging decisions given the current political and economic uncertainty in South Africa,” says Hall at Standard Bank.
Paizis at Absa Capital agrees. “While there’s often no specific correlation between what happens abroad and what happens here, it’s true that we’re very much a victim or beneficiary of global risk aversion or risk tolerance. Whenever headwinds come along, people often bail out of rand-denominated products.” However, Paizis attributes the current defensive attitude of clients to the impact of a slow economic environment as well as industrial unrest, which reached a bloody peak recently when 36 workers at the Marikana mine were shot dead during clashes with authorities on August 16. “Since the start of the traditional striking season, we’ve seen a lot of the real-money participants selling rand-denominated products. The effects of this sell-out gradually work their way through to the OTC derivatives market, and that can affect liquidity. But, optimism and pessimism are often short-lived in South Africa. At the moment we’re going through a bad patch, but it may not be a long-term problem.”
That’s not true of one corner of the equity derivatives markets. After dodging a securities transfer tax bullet last year, participants were hit with the introduction of a dividend withholding tax in April (Risk October 2012, pages 58–59, www.risk.net/2112197). This imposes a 15% tax on dividend receipts for shareholders and, according to Tinus Rautenbach, head of equity derivatives at Investec Capital in Johannesburg, has led to a drop in volumes. “A lot of the traditional dividend funds were hit pretty badly, and had to close down due to the sudden lack of liquidity in equity dividend instruments,” he says.
There are other potentially long-term clouds, too. This time last year, South African banks were beginning to grumble about trade pricing discrepancies introduced by the credit valuation adjustment (CVA), a trading book capital charge contained within Basel III that accounts for the counterparty credit risk in any given deal. If the grumbling has abated somewhat since then, the pricing discrepancies certainly haven’t. “All of the major banks in this country have spent much of 2012 adjusting to the new pricing regime necessitated by Basel III, but at very different speeds. It has probably been quite a confusing time for clients due to the variability of quotes they’re getting from various banks.”
The pricing impact of CVA is particularly marked for long-term, uncollateralised trades. In 2011, dealers in developed markets estimated that the basis-point cost of a 30-year, uncollateralised interest rate hedge could increase sevenfold due to the introduction of this charge. That leaves many clients, particularly corporates, with some unappetising choices. They can pay through the nose to keep trading as usual, start posting collateral, alter their hedging strategy or simply stop hedging altogether. Alternatively, regulators could ride to the rescue, and it seems likely that Europe’s legislation to implement Basel III – the fourth capital requirements directive – will incorporate a CVA exemption for trades with corporates. Some South African dealers believe their own regulators will follow suit. “Fortunately, our regulators often look offshore for guidance on best practice, so there’s a good chance any corporate exemption will be adopted here as well,” says Paizis at Absa Capital.
Others aren’t so keen. “I really don’t see the point in lobbying in favour of holding less capital against counterparty risk. It seems perfectly sensible for banks to hold more capital for these sorts of activities,” says Hall at Standard Bank. “What I would lobby extremely hard for is an exemption from the compulsory clearing and margining of corporate trades. Most corporates aren’t set up to deal with frequent margining. If you phone up a South African corporate treasurer and tell him he owes you 15 million rand tonight, he’ll say ‘sorry, my financial director is in Namibia and isn’t back until Tuesday, can you ring back then?’. It just doesn’t work. Being allowed to extend credit to corporates is pretty fundamental to the banking sector. One of the ways we do this is by allowing them to have mark-to-market exposures on their derivatives without posting margin.”
Hall is also on the warpath against Basel III’s two new liquidity ratios – the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR). The LCR aims to ensure that banks hold enough liquid assets to survive a 30-day period of severe market stress, and will be introduced in 2015, while the NSFR makes banks more closely match long-term assets and liabilities. It will be fully implemented in 2018.
The problems the LCR causes for South African banks –along with their peers in other jurisdictions such as Australia, Singapore and Denmark – have been known for some time. Basel III designates a very short list of assets as liquid, and many jurisdictions do not have enough of these assets to go around. The SARB has set up a liquidity facility to help banks meet their LCR requirements, but dealers do not see it as a long-term solution. “Unless the list of eligible assets changes, this can’t be considered an interim measure, but whether it will work in the long run is debatable,” says Hall.
The viability of the NSFR in South Africa also remains in doubt. The obvious way to satisfy the measure is a big base of retail deposits – a business that is relatively small in South Africa.
“South African banks are unlikely to find the required term funding for the NSFR in the domestic markets. If implemented as currently written, we’ll have to find funding offshore. If we are forced to do this, it increases the risk of an offshore crisis spreading directly into South Africa because those funding lines might get pulled away. It’s an awful position for South Africa,” says Hall.