For the past decade, Italy has been unable to issue US dollar debt because of its out-of-the-money derivatives portfolio. It owed banks more than €30 million at the end of 2017, which meant any new cross-currency swap that could bring the dollar funding back to euros would include such high counterparty credit and funding costs it would make the whole deal uneconomic.
The solution? Signing collateral agreements known as credit support annexes (CSAs) with its multiple primary dealers to slash these add-on costs, known as derivatives valuation adjustments (XVAs). This paved the way for the sovereign to issue $7 billion of debt and swap it back into euros in October 2019 for the first time in almost 10 years. It repeated the trick in 2020, issuing a five-year US dollar bond to raise $3 billion and swapping it back to euros.
“The role of the CSAs is to significantly lower the charges we pay on our derivatives, as without collateralisation the charges are very high, and are one of the reasons why we’ve been absent from the dollar market for so many years,” says Davide Iacovoni, director general of public debt at the treasury department of Italy’s Ministry of Economy and Finance (MEF).
Italy has long been known as one of the biggest sovereign users of derivatives. It has mainly used euro interest rate swaps to pay a fixed rate and receive floating to hedge against a rise in rates. But euro rates fell dramatically after the 2008 crisis, and continued falling during the European sovereign debt crisis and beyond, pushing the country’s portfolio further and further out-of-the-money.
At the end of 2017, Italy was €31 billion out-of-the-money on its €127 billion notional derivatives portfolio, consisting of interest rate swaps, cross-currency swaps and sold swaptions. Of this, it was €28.5 billion out-of-the-money on its pay fixed interest rate swaps.
The uncollateralised nature of these swaps threw up a number of problems. They create counterparty credit risk for dealers, which have to hold capital against the exposures and account for them in their earnings. Dealers also typically hedge the trades with cleared positions, which require variation margin. As the margin is not coming in from the sovereign, the dealer has to fund the collateral for its cleared hedge, generating a cost known as funding valuation adjustment (FVA).
The size of Italy’s negative mark-to-market balance was so high that the CVA and FVA costs for a new cross-currency swap would make a US dollar issuance uneconomic.
Also, big negative mark-to-market balances require dealers to hold capital against them. Fears emerged that Italy’s dealer group would be unable to take on much more new exposure, and that it could also constrain their ability to act as a primary dealers for Italian government debt.
The role of the CSAs is to significantly lower the charges we pay on our derivativesDavide Iacovoni, Italy’s Ministry of Economy and Finance
Starting in 2018, Italy’s MEF decided it was time to enter two-way CSAs with its swap counterparties. Starting with legacy positions, Italy first forged CSAs with dealers that have more than €4 billion of exposure, later expanding the exposure cut-off to dealers with more than €3 billion of exposure.
The CSAs for legacy trades are structured such that the full mark-to-market will be paid over time, with a posting cap that would rise incrementally over time. Swaps reaching maturity and rolling off would also help this balance decrease. As of September 30, Italy had paid €3.3 billion in collateral against the mark-to-market of its derivatives portfolio, which had actually blown out to €38 billion due to the Covid-driven collapse in euro rates last year.
“The fact the banks know we are contracted to post increasing margin over time is already a huge benefit to them, as it guarantees an expected exposure to us over time,” says Iacovoni.
The CSA negotiations with multiple dealers were no easy task – especially as a 2017 Italian ministerial decree stated that the MEF could only post collateral on its existing derivatives “provided that the Treasury achieves an economic benefit as a result of including such transaction(s) under the collateral agreement”.
It was decided that this benefit would come in the form of a rebate from the banks, taken from the savings they achieved from Italy collateralising its trades. For instance, when the trades are collateralised, the amount of capital they might have to hold against CVA declines, and they do not have to enter or maintain as many hedges of Italy’s counterparty risk that would have otherwise reduced that capital requirement. FVA costs are also reduced because the banks are receiving margin from Italy that they can use to fund margin calls on their cleared hedges.
“It’s a very complex decree, and so it took a while to come to a final agreement on those CSAs with each of our counterparties. Once we did so, the banks paid us that benefit and then our derivative positions were put under a CSA,” says Iacovoni.
CSAs were also created to cover new swaps entered into with dealers. This type of CSA was completed with all of Italy’s primary dealers in the first part of 2019.
The existence of the new CSAs meant it finally made economic sense for the sovereign to return to the US dollar debt market in late 2019 and swap it back into euros via cross-currency swaps.
“The cost of swapping dollars back into euros has always been too high for us to bear and so it really was impossible for us to be in the dollar market up until now, but the CSAs lower the charges we face. As a result, dollar bond issuance or interest rate swaps become much more bearable in terms of cost,” says Iacovoni.
Italy also tackled an old problem with its debt auction process that was raising concerns about potential impacts on investor appetite.
Under Italy’s old auction rules, the MEF would pay a rebate to primary dealers buying Italian government bonds in order to incentivise participation in its auctions – with such rebates being paid to market participants during the settlement process for the products participants had purchased.
However, this meant dealers would often add these rebates onto the bid price, knowing they would quickly recoup them from the MEF, resulting in overbidding in the primary dealer market and a dislocation between prices in the primary and secondary markets. Such activity also created a lack of transparency as to what the final price of a product was when the dealers sold those bonds on to their clients, as it was typically unclear whether dealers were charging net or gross of the rebate.
Sometimes this apparent net price was higher than the secondary market levels, leaving final investors unhappy and creating a concern within the MEF that underlying demand for such products would be affected. At times, this led dealers – who have a commitment to buy at the auctions – to offer discounts to buyers in order to increase demand, as well as creating a way to move the bonds off their balance sheets.
Adding to that was the perception that primary market auctions were expensive compared with the secondary market, possibly incentivising banks to instead buy their bonds in the secondary market – which could potentially lower the demand coming into the primary auctions and create uncertainty for the MEF.
The whole supply chain, from the issuer to the final investor, is therefore more efficient for all participantsDavide Iacovoni, MEF
In July 2020, the MEF looked to fix the problem by reducing the rebates paid to the primary dealers, and to pay them not at settlement but together with the other auctions at the end of the quarter. Spacing out the payment of the rebate from the purchase of the bonds means dealers can’t account for them on a net basis, which they could do if the rebates were made straight away.
To manage that risk, banks are thus forced to come into the auction at a price consistent with secondary market level, with discounting practices and overbidding having reduced as a result. At the same time, dealers still receive some rebates for participating in the auction. The alternative was removing the rebates altogether.
While some dealers were still overbidding initially, by late August the system was functioning fine, with spreads between primary and secondary debt markets falling to around 0.5-1.5bp. Italy bears the cost of this, as lower prices in the primary market mean the interest costs are slightly higher, but the MEF is happy to bear this in order to have a better-functioning market.
“Primary dealers and final investors really appreciate this new regime, not only for the rebate that dealers receive as compensation for their participation in auctions but also for the fact that they can buy important shares of our debt on the primary market with much less impact on the pricing level on the secondary market. The whole supply chain, from the issuer to the final investor, is therefore more efficient for all participants,” says the MEF’s Iacovoni.
Like many countries, the impact of Covid-19 meant it needed to increase issuance. Italian debt issuance increased by around €67.25 billion between April, May and June, according to figures from the MEF. Overall, debt issuance increased by around €144.83 billion from December 2019 to December 2020.
One way the sovereign was able to do this was by utilising syndications for bonds with maturities under 10 years, something Italy had only previously ever done for instruments such as long-dated nominal and inflation-linked bonds.
“In that way, we didn’t have to rely too much on the balance sheets of primary dealers as syndications allow you to sell the bond with intermediation of primary dealers and a few brokers if needed, so that they can reach the buy side in size. These transactions were all extremely successful, so syndication worked very well,” says Iacovoni.
Earlier in the year, the sovereign also utilised government bond trading platform MTS to introduce tap issuances. This saw the MEF email primary dealers about whether they had a short bond position and therefore wanted the MEF to re-open specific bonds, with the MEF often holding a tap issuance the following day. Indeed, Italy issued more than €4 billion in debt this way over May, June and July.
The MEF also created a new retail product to increase the proportion of debt held by the Italian retail sector on the one hand, while helping to fund Italy’s response to the ongoing coronavirus pandemic on the other.
The BTP Futura is an eight- to 10-year retail product that provides market participants with a premium at maturity equal to the average nominal GDP annual growth rate over the life of the bond, with a 1% floor and 3% cap.
Proceeds are used to help fund Italy’s response to Covid-19, such as providing small business loans, paying unemployment subsidies for people who had become unemployed, and paying for necessary healthcare equipment in lieu of raising taxes.
“Using the BTP Futura to help finance all of these responses to the pandemic was a good idea that really worked and that people liked. They liked the idea of buying bonds to help their country,” says Iacovoni.
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