While the approaches for single currency trades have altered significantly from earlier proposals, the treatment of cross-currency swaps remains unchanged – despite protests from some banks in Asia-Pacific at the end of last year. The Isda working group had suggested multiple currency transactions be allocated to the US dollar silo, but Japanese banks in particular had complained that approach might create problems for banks that don’t fund in dollars (Risk January 2012, pages 74-78). This prompted a rethink by Isda – with counterproposals including a cascade structure, where a trade is allocated to a particular silo based on the composition of the currency legs, and a free choice. However, Isda decided to stick with the original proposal after conducting a vote earlier this year, in which 63% of respondents favoured the US dollar bucket as a first choice.
Despite these differences in opinion, the silo approach should eliminate many of the problems that currently exist by removing the optionality embedded in the CSA and aligning practices with LCH.Clearnet. But it creates new complexity – 17 separate silos means 17 different collateral flows could, in theory, end up going back and forth between each set of counterparties each day, creating cross-currency settlement risk, or Herstatt risk. That doesn’t exist under the existing document: if two dealers had traded a dollar and a euro swap and those positions were completely offsetting, collateral would only be exchanged on the net exposure, which would be zero. Under the new framework, a dollar collateral flow would pass in one direction, and a euro payment would be made separately in the other.
Aligning the core variation margin structure across cleared and bilateral hemispheres of the market makes risk management sense
The Isda working group has devised two solutions to resolve this problem. One is a payment-versus-payment (PVP) settlement system, similar to the service CLS Bank provides to the foreign exchange market. However, this will take time and money to build – while Isda intends to put out a request for proposal later this year, a quick launch is unlikely.
Consequently, an alternative approach will be rolled out for the first phase of implementation. Dubbed the implied swap adjustment (ISA), it essentially allows counterparties to net the various collateral flows into a single payment in one of the G-7 currencies: Australian dollar, Canadian dollar, euro, sterling, Swiss franc, US dollar and yen. The adjustment will be based on foreign exchange spot rates, tomorrow/next day (tom/next) forex swap rates and OIS rates, with Isda publishing a daily fixing of the relevant data. Each counterparty will be able to choose which of the G-7 ‘transport’ currencies to settle in, and can switch up to two times each calendar month by giving two business days’ notice.
So, if a US dealer and Japanese bank have outstanding swaps in euro, yen and dollars, the trades would be split between the three currency silos, and the relevant discount rate would be used to value the trades in each bucket. However, the Japanese bank might decide to use the ISA to settle anything it owes in yen only, while the US dealer might opt to post collateral in its own domestic currency.
This method appeals to a number of banks – including those in Japan, which had been worried about being forced to settle in US dollars. “The best solution for us is the price adjustment. We want to settle in yen, even if we have euro or dollar swaps. The most practical way is to have a choice in settlement currency,” says Yutaka Nakajima, senior managing director, head of trading, fixed income Japan, at Nomura Securities, and an Isda board member.
In fact, some question whether the PVP solution is needed at all and suggest market participants may ultimately decide to stick with the ISA. “Consensus is that if the ISA methodology works, then the push for PVP will be on the backburner,” says Feil at Deutsche Bank.
Not everyone agrees, though. Some dealers argue the ISA methodology is complex, and introduces an additional manual process that increases the chances of error. Problems could also emerge in the unbundling of the transport currency back into the individual cash positions needed to fund the book, they claim. Banks would want to make that conversion at the fixing rate – but the level at which they actually trade may not exactly match the official tom/next foreign exchange swap fixings published once a day by Isda.
“We can all look at this 11:00am fix, then at 11:01am I am going to be busy finding someone to trade with at a rate as close to the fix as possible. Potentially we are creating a scramble each day to convert currencies when it might be more efficient to exchange the underlying currencies,” says Joshua Luks, fixed income treasurer at BNP Paribas in London.
As a result, several banks say they will likely wait for the PVP solution to emerge before adopting the standard CSA. “We much prefer the CLS-type settlement. That way, we can systematically distribute the right amounts to our business units. We voted for the standard CSA, but we decided to wait for the CLS-type solution,” says Guillaume Amblard, global head of fixed-income trading at BNP Paribas, and an Isda board member. At least three other big European banks have similar opinions.
Those close to the working group concede the ISA calculation would add an extra layer of complexity to the process, but point out that banks are already doing something similar today whenever a net collateral payment is made in a particular asset chosen from a list of eligible collateral. Even putting that aside, the conversion back out into the underlying cash positions will not necessarily occur on a transaction-by-transaction basis, they say.
“The desire to execute at close to the fixing rate would be relevant if banks were taking their transport currency and swapping it into the 17 currencies every day, but they may not actually do that. They may have other activities through the corporate treasury function, which means they have different currencies flowing in and out every day anyway. Foreign exchange transactions may be done as part of that overall treasury function, but those would not necessarily be done at the rate implied by a single transaction – it would be more of a portfolio funding issue,” says one dealer.
Either way, the PVP solution will not be available until next year at the very earliest – possibly later. That means only a core group of dealers will likely implement the standard CSA in the first phase. A few buy-side firms have been involved in the discussions, but are not expected to be among the first adopters – in fact, asset manager BlackRock has decided to renegotiate existing CSAs in order to cut back the list of eligible collateral to a single asset for each agreement.
“Based on our discussions with firms, we estimate about half a dozen firms will adopt this in the first phase. There are buy-side firms that have shown interest, but I don’t think they will be among the first six volunteers,” says Kayiira at Isda.
The document will be voluntary – and Isda acknowledges it may not be appropriate for certain client types to implement at all. Some banks may decide to hold off until the PVP solution is up and running; others might decide to stay on the existing document. Several of the largest dealers, however, are keen to get going.
“We will be in the first phase, and we have put everything in place internally. The operational side is always the issue, and every bank has to keep an eye on budgets. To implement, you need to have the budget, the people and the time,” says Feil at Deutsche Bank.
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