Life is full of little ironies, and this is sometimes – very occasionally – true of the derivatives markets too. To give an example: politicians, central banks and regulators are pushing for banks to clear over-the-counter derivatives through central clearing houses, as well as calling for non-cleared derivatives to be backed by collateral whenever possible. That seems sensible. But here’s the irony: those clients most vehemently opposed to posting collateral to banks to cover mark-to-market losses on derivatives trades are sovereigns and central banks. The implications are significant. Transactions conducted under a one-way credit support annex (CSA) – as most trades with sovereign, supranational and agency clients are – would require the dealer to post collateral when the trade is in the sovereign’s favour, but this would not be reciprocated if the opposite were true, meaning the bank has credit exposure to the sovereign. That’s not all. Banks would tend to hedge their exposure in the dealer market, so a positive exposure to the sovereign would be mirrored by a negative exposure to the hedge counterparty. That means the dealer would be required to post collateral to the hedge counterparty (trades in the interdealer market are conducted under two-way CSAs), but would not receive collateral from the sovereign, landing the bank with a potentially hefty funding requirement. This poses the simple question: so what? For a start, the exposures are massive. Five banks shared the size of their funding obligation as a result of sovereign one-way CSA derivatives exposures with Risk. It amounts to almost $30 billion. A rough back-of-the-envelope estimate suggests the figure for the industry could be around $150 billion. Despite this, many sovereigns say the push to collateralisation should not apply to them. And why would they? In theory, this cost of funding for the dealer from a one-way CSA should be passed on to the sovereign in the form of higher prices, but in practice this is patchy – many dealers are willing to waive the cost to win sovereign business. But this leaves the industry with a huge funding obligation that could blow up in a worst-case scenario. There are other implications to this. Non-cleared trades without any form of credit mitigation attract the highest capital charges. With sovereigns opposed to posting collateral, banks are forced to look for alternatives – and this means the credit default swap (CDS) market. As more sovereign CDS protection is purchased to hedge sovereign exposures, spreads are pushed higher and higher. The result is another little irony – claims by furious politicians that speculators are forcing spreads wider by shorting sovereign credit, and calls for a clamp down on the sovereign CDS market....
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