For the past several years banks have been waging a sort of propaganda war against non-cash collateral. Buy-side firms have got used to hearing their credit support annexes (CSAs) labelled either 'clean' or 'dirty'. Repeatedly they have been told clean – cash-only – CSAs are more capital-efficient for banks and will lead to better pricing for clients. Many have succumbed to pressure to switch to cash-only arrangements.
So you can imagine their surprise to find this picture of good and bad sometimes gets inverted.
Such instances are rare – so far – but that is what happened to one North American insurer earlier this year when it tried to unwind a long-dated interest rate swap. On the face of it, you might expect the bank to welcome the reversal of a trade for which the CSA allows posting of securities as well as cash, with the trade heavily in-the-money to the insurer.
Instead, banks see such an unwind as a step closer to a net in-the-money position, where they would be receiving bonds as margin, which is punitive under the Basel III leverage ratio. As a result, the bank proposed unwind charges the insurer dismisses as "ridiculous".
"They came up with a charge they knew we wouldn't pay," says a trader at the insurer. The company decided not to go ahead with the unwind. "Translated into basis points I think it was 16bp." The charge equated to $1.2 million, the trader says. The insurer's trading desk struggled to understand the bank's reasons.
"They haven't been completely clear with how they got to that number," although the intersection of capital rules and how the unwind would change the insurer's position with the bank was the basis for the calculation, he explains.
There have been other similar instances with other banks, he says. "No trade is easy to get off these days. The past two months have been brutal. Even for plain vanilla swaps, getting out of trades is difficult."
The chief risk officer of another leading North American insurer says he is aware of other firms experiencing similar things, but asserts his firm has not faced such difficulties yet. The derivatives head at a European asset manager says likewise. Meanwhile, Risk.net understands several banks are imposing capital-based charges to unwind or restrike trades depending on how doing so changes the collateral position of portfolios.
Even so, some on the buy side are yet to encounter the problem. These firms say they are seeing unwind charges in specific markets such as total return swaps, but not yet for vanilla swaps, or they have encountered unwind charges but relating to the specific issue of negative interest rate floors.
The insurance company trader thinks these firms are yet to fully grasp what is happening. "People are going to regret having legacy trades on in a few years' time," he says. If he is right, insurers and pension funds that typically receive fixed to hedge long-duration liabilities should be particularly concerned. Low interest rates mean their swaps are generally in-the-money, and unwinding or restriking trades has been a popular way for them to unlock value and put it to work to generate yield.
Those firms might think now is a good time to put on trades before new bilateral margining rules take effect, he says. "But if they need to change those hedges because the underlying liabilities change, they are going to find out how expensive it is."
Unwind charges are the latest example of the upending of conventions in the pricing of derivatives in recent years as banks have started to price in counterparty risk, funding costs and more recently the cost of capital. Familiar approaches to discounting using overnight index swaps, for example, are giving way to using a rate that reflects real funding and capital costs for trades.
The progression towards setting prices to include capital consumption has been steady, but market participants say it has gathered speed recently. "It felt like January 1 this year was a tipping point," says Paul Fulcher, managing director ALM structuring at Nomura in London.
However, approaches to pricing differ widely between firms, largely because capital is the binding constraint for some dealers but not others. This is what has led to some banks imposing unwind charges even where clients are heavily in-the-money. "It seems capital risk is overtaking market risk in terms of what the traders care about," says the insurance company trader.
The nub of the issue is the treatment of non-cash collateral under the leverage ratio, which prevents banks offsetting non-cash collateral against their derivatives exposure. Cash collateral by contrast can be offset, which is one of the reasons banks have pushed for the move to cash-only CSAs.
A few times we have had to do overlay trades because we didn't want to pay up what we saw as ridiculous charges to get out of trades where we were up money
Insurance company trader
Long-dated swaps with 'dirty' CSAs are generally seen as punitive under the rules so unwinding them would seem attractive. But if doing so puts a bank in-the-money to a counterparty across its portfolio, and the counterparty is able to post non-cash collateral, the unwind creates a capital cost to the bank.
The logic holds even if the client stays in-the-money. An unwind might remove a position where the bank is out-of-the-money, thereby increasing the chance it will no longer be posting to the counterparty at some point in future.
To give a simplified illustration, imagine a client has traded two swaps with a bank – both receive fixed, one at 4% and one at 2%. Both are in-the-money to the client, but unwinding or restriking the 4% swap moves the bank much closer to receiving collateral. A small increase in rates would lead to the bank receiving bonds with a commensurate charge under the leverage ratio.
Erik-Jan van Dijk, head of treasury and derivatives at Achmea Investment Management in the Netherlands, recognises the scenario: "If the value is high and banks are posting cash, there is no major leverage ratio impact. A reset of the swap reduces the value of the swap to zero. This means a much higher probability that the swap will get in-the-money for the bank. Because the client is not cash-rich they will post securities with a major leverage ratio impact [for the bank] as a result."
Van Dijk is unsure how widely firms find themselves in such circumstances but thinks charges could lead to a "multiple" of the costs they would otherwise face.
An option for buy-siders would be to use overlay trades to change their position rather than unwinds, but such an approach is useless if they wish to monetise value in a trade. Overlays also add to the number of potentially troublesome trades on their books, doubling down on a problem rather than making it go away.
"Our hands are tied," says the insurance company trader. "A few times we have had to do overlay trades because we didn't want to pay up what we saw as ridiculous charges to get out of trades where we were up money." Most buy-side firms also prefer to shrink positions to make them easier to track rather than add to them.
A London-based structurer at a global bank says: "If you are unwinding the trade because you want your cash back then putting on the offsetting swap isn't going to help. And if you do the offsetting swap with sovereign bond collateral then you have two swaps that aren't future-proofed rather than one."
If most buy-side firms are yet to run into big unwind charges, a possible reason is that pricing practices vary so widely on the sell side.
"I don't think there is a consistent treatment from one bank to the next," says a senior rates trader at a bank in London. "Different businesses have different return requirements and ways of measuring the impact of a trade. Also the effect of the exclusion of one particular trade will depend on the shape of the rest of the portfolio. It is difficult to see how commonalities would arise across the industry."
It is clear the leverage ratio is a more prominent consideration for some banks than others. Barclays, Credit Suisse, Deutsche Bank, Morgan Stanley and UBS, for example, are banks where leverage considerations are likely to be more of a binding constraint, compared with JP Morgan, Bank of America Merrill Lynch and Citi where risk-weighted assets are probably a more important consideration.
You have got to be careful with a dealer that is aggressive on the way in because they might be thinking they are going to charge you on the way out
Barry Seeman, Aegon
One banker talks of a "notable asymmetry between European and US banks in terms of the consequences of the regulation". With banks now reporting leverage ratio numbers in the run-up to the rules becoming binding in 2018, pressure has grown on those that are more exposed to reflect the ratio's impact in pricing.
In a presentation seen by Risk.net prepared by Credit Suisse for clients, the bank makes clear how assumptions about the leverage ratio cost of derivatives over their lifetime will directly influence pricing. And Risk.net understands Barclays is among other banks also pricing potential capital consumption into swap unwinds. Spokespeople from Barclays and Credit Suisse declined to comment.
Still, the wider picture of how individual banks treat pricing is fuzzy because it often differs from client to client. Also, pricing capital costs across a portfolio is highly complex and time-consuming, meaning it cannot necessarily be done for every trade.
Banks struggle to know the true capital cost over the lifetime of long-dated trades, forcing an element of judgement into their decision-making. In response, some are taking a pragmatic approach and treating capital allocation as part of a wider commitment to the client.
"Pricing capital in on a trade-by-trade basis can become quite complex," says Thomas Ellerton, a director in rates structuring and solutions at Citi in London. "If it is done on a business-wide basis then it can be phased in or you can judge the necessity of whether that balance-sheet element comes through as a charge."
In reference to new trades, he gives the example of a client with a high turnover of derivatives where there is a good chance they will restructure or unwind a long-dated trade within two years. "A client might be putting on trades to gain market risk over a short period of time then unwinding, so even though it's a 30-year trade you are only expecting to hold capital against it for the next two years. You can look at the bigger picture about what that business means for the firm rather than take it on a standalone basis."
"For a 30-year swap you need to take a view as to how you think regulation is going to look over the next 30 years, which is very difficult to do," he points out. "There is an extent to which banks need to stomach some of these costs as a price of doing business."
The practical difficulties for banks of making leverage ratio calculations on a portfolio-wide basis are huge, says Eric Viet, head of financial institution advisory at Societe Generale in London: "You need to recalculate the mark to market of the whole book for all scenarios to come up with the leverage and capital position. To do that on a portfolio where you could have hundreds if not thousands of positions with one client, in different markets, with correlations between different markets, is extremely complex." To do so for anything but the biggest trades is unrealistic, Viet feels.
But he adds: "Most insurance companies will have long receiver positions so it is hard to see how unwinding a single trade would leave them with a net payer position."
Partly as a result, some buy-side firms think the circumstances that lead to significant charges are unlikely to arise with certain dealers. Barry Seeman, head of US derivatives and hedging at Aegon in Baltimore, says: "You are going to find that firms will have large receive-fixed swap portfolios and it would be hard to think lifting one trade would immediately reverse the collateral postings of one of those portfolios."
And yet, such a scenario might be more likely in certain markets, says Viet. UK insurers are generally less in-the-money than European firms, because of a tendency to restrike trades in the past as rates have come down, and unwinds by those firms might leave banks receiving collateral. Meanwhile, insurers in the US might be more concerned about charges if they expect interest rates to rise, reversing the collateral position on their portfolios, he says.
Looking ahead, capital-based unwind charges appear to be just one of a growing list of changes to pricing practices that buy-siders must get to understand.
Seeman talks about the weakening of past conventions where pricing in and out of trades would remain broadly in line. "The challenge you face long-term is your firm's perception of liquidity and the tight pricing of the uncleared derivatives market. You have got to be careful with a dealer that is aggressive on the way in because they might be thinking they are going to charge you on the way out."
Simply to blame sell-side firms would be wrong, he concludes: "Dealers have to be very cognisant of their return on capital and how they are dealing with their best clients." But he adds: "Relationships between banks and their clients are being tested, and if certain banks are plotting this type of pricing strategy, they may not be a long-term provider to the client."
Additional reporting by Catherine Contiguglia
The week on Risk.net, May 12-18, 2018Receive this by email