Sovereign swaps users should learn from Italy’s mistakes
Posting collateral is a cost debt offices must embrace, argues New Sky Capital's Stefania Perrucci
Would Italy have a different book of derivatives if it had always been required to post collateral to its dealer counterparties?
It’s impossible to know, of course, but the question is worth asking because of the situation the country now finds itself in. The derivatives portfolio amassed by the Tesoro – the state treasury – had a notional value of €111.3 billion ($126 billion), with a mark-to-market value of negative €29.8 billion, as of December 31, 2018.
In the post-crisis years, banks have become less willing – and less able – to carry this kind of exposure, which has a tangible burden in the form of counterparty exposure, capital requirements and funding costs (the latter arising because the dealer has to fund collateral for any offsetting hedge if it is not receiving collateral from a sovereign client). In theory, Italy should shoulder these costs, but it cannot afford them either.
The result has been slow, tortured progress towards a new policy on collateralisation – a step many sovereign actors have resisted. Collateral posting reduces the risk and funding burden for dealers and – an overlooked point – it also encourages better behaviour by derivatives users. It is a lot harder to rack up billions of euros in liabilities, or to disguise them, if those liabilities generate day-to-day funding costs.
At the end of 2017, and at the start of this year, Italy’s finance ministry passed two decrees allowing it to collateralise both new and legacy derivatives trades. It comes too late – Italy is not about to cough up the best part of €30 billion in cash and bonds to its dealers. Rather, the measures will likely allow the country to maintain its current opaque policy of restructuring its legacy derivatives exposure, possibly with less reliance on new derivatives in the future.
Debt offices around the world – and other sovereign derivatives users – should learn from this.
Political accountability
Sovereigns have used over-the-counter derivatives as part of their debt management strategy for decades. Derivatives provide flexibility to the debt manager, but also introduce multiple layers of complexity, which tend to run counter to transparency, and thus accountability.
Disclosure of derivatives activity in public debt management is still lacking in substance. Requests for more granular data have met the opposition of several parties, including banks, sovereigns, and at times even of regulators such as the European Central Bank. The stated concerns, that more detailed disclosure may have detrimental effects on financial stability, remain unconvincing. Some of the pushback on disclosure may be political instead.
Disclosure of derivatives activity in public debt management is still lacking in substance
Stefania Perrucci
The truth is that without transparency, there is no accountability. Without accountability, trust is eroded, and this is the real threat to financial stability and to the institutional and political system as a whole. Importantly, while technical responsibilities rest with the debt manager, accountability should not stop there, as by virtue of reporting line, debt policy is typically influenced by political agents as well.
It is in the public domain that, in the 1990s, off-market swap transactions were used for window-dressing by some countries, including Italy, in order to fall within the budget requirements of the Maastricht Treaty. That means accountability for such policies should be political and not just technical – debt office managers who move into positions of broader responsibility should not be able to shield their past actions from scrutiny.
Credit asymmetry
Up to the late 1990s, it was rare for a sovereign entity to have a credit support annex (CSA) to manage counterparty risk – the standard document used to govern collateral posting in a derivatives trade. Over time, one-way CSAs became common – requiring dealers to post collateral, but not sovereigns. These arrangements still allow many countries, including Italy, not to worry about funding their derivatives exposure. This avoids any impact on debt accounting and gives derivatives an edge relative to the tweaking of issuance in the primary market. It is a business booster, where debt managers acquire flexibility in budget alchemy, and banks collect revenues for providing it.
The asymmetry in credit status may seem to bestow an economic and strategic advantage to the sovereign. However, it is not as clear cut as it looks. For a start, such preferred treatment may have disincentivised the development of an appropriate risk management culture among debt managers. It is likely that if collateral funding had been required, the Tesoro would have developed the capability to price its derivatives much earlier than it did. Speaking in front of an Italian parliamentary commission in 2015, the Tesoro’s director-general at the time testified that the debt office did not have the deal-level data necessary to correctly price its derivatives, at least until that point.
Sovereigns would also have been encouraged to more closely monitor the terms of their trades, including any additional termination event clauses. These allow dealers to close out a trade at specified points in its life, as Morgan Stanley famously did in the case of Italy in 2011.
Scenario analysis of potential future exposure – and the accompanying funding costs – may have been pursued as well.
Instead, the preferred credit status came at the cost of lax discipline in the ongoing monitoring of market, credit and operational risk.
It is likely that if collateral funding had been required, the Tesoro would have developed the capability to price its derivatives much earlier than it did
Stefania Perrucci
Moreover, the economic advantage of one-way CSAs is washed out by the fact that bank counterparts have to price this asymmetry and pass its costs on to the end-customer, via a family of valuation adjustments – XVAs – for capital, counterparty and funding costs. This is done through the course of normal or ancillary business, whether in new derivatives or primary issuance deals, or in the ongoing restructuring of derivatives books – restrikes, maturity transformations, novations – that arises from their shifting counterparty and funding exposure. In short, these costs are just made more opaque, to the benefit neither of the sovereign, nor of public accountability.
The Italian case is interesting because of the large size of public debt, making any strategic tilt in policy a material one1. In terms of aggregate notional outstanding as a percentage of debt, the derivatives activities of the Tesoro do not look unusual among its peers. Interestingly, debt officials have recently stated that, going forward, the Tesoro will probably just be involved in the use of cross-currency swaps to hedge foreign currency issuance that may resume, maybe in US dollars. Interest rates swaps and swaptions seem to have lost favour, which is a notable strategic tilt in itself.
The Tesoro stands among very few peers in having used an option-selling strategy, and it’s not clear why it did so2. In a report from 2000, the Tesoro stated that it did not issue callable bonds, the embedded option in which could be hedged by selling receivers.
To make things worse, these swaptions, and their legacy swaps, have been the object of multiple restructuring over the years, as a way to manage – or smooth – budget implications.
This makes the analysis of the Tesoro’s activity using public information akin to investigative work in the dark. In any case, given that the restructuring of legacy positions is still ongoing, and that credit exposure is the underlying driver of such activity, it is important to know what changes in collateralisation policy, if any, the Tesoro may be planning for the future.
Restructuring strategy
The Ministry of Economy and Finance (MEF) issued a decree on December 20, 2017 relating to the use of bilateral guarantees on derivatives. This allows – but does not mandate – new derivatives transactions to be subject to bilateral collateralisation.
The Tesoro may also post collateral on legacy transactions, subject to severe conditionality. The first condition to be met is that exposure to Italy be above a minimal threshold; the second is that the Tesoro must gain a positive economic benefit as a consequence of the posting of such collateral. This probably means a pricing concession from the dealer – which sees its XVAs reduced by the posting of collateral – or a novation to another counterparty. This is a virtuous clause, but is likely irrelevant in practice. Other conditions are that collateral posting should be subject to liquidity and budget considerations.
Last, the decree states there will be limited resources set aside for the collateralisation of legacy transactions.
In a follow-up decree on January 2, 2019, the MEF set the minimum counterparty threshold for collateralisation of pre-existing exposure at €3 billion.
These directives suggest the Tesoro has no intention of posting collateral to cover its large legacy credit exposure. The strategy is still to restructure pre-existing exposures, despite opacity in costs, and to spread the cashflow impact into the future, in order to avoid the budgetary implications.
The apparent reluctance to post collateral on legacy exposure is understandable as collateral needs to be funded, thus impacting debt accounting
Stefania Perrucci
For new transactions, the strategy seems to be to increase the number of available counterparties for diversification and novation alike, with less overall reliance on derivatives in the future.
The apparent reluctance to post collateral on legacy exposure is understandable as collateral needs to be funded, thus impacting debt accounting. As a further complication, the Tesoro’s counterparties have little incentive to accept Italian debt as collateral against an Italian default – it could mitigate a dealer’s funding costs, but would offer no credit relief. Cash collateral would mitigate both funding and credit-related costs for dealers, but given negative deposit rates the Tesoro may actually have to pay interest on any cash it posts.
In other words, with the treasury unable to own or source higher-yielding, high-quality assets uncorrelated to its own credit risk, the funding cost of collateral is de facto maximised and potentially material given the large size of the negative credit exposure involved.
As a back-of-the-envelope estimate, if Italy currently funds itself at an average interest rate of 2.8% and needs to pay the deposit rate of 0.4% on cash collateral, this amounts to an annual cost of 3.2% on an exposure of around €30 billion, so about €1 billion per annum.
Public scrutiny
The fact that derivatives offer flexible ways to manage cashflows is both virtue and vice. As a matter of policy, bilateral collateralisation may provide better incentives to keep in check any gaming of cashflows and budgets, as well as the institutional and political hazards that come with it.
Derivatives and collateralisation policies are areas where closer collaboration between the Tesoro and the Bank of Italy may bear fruit. It makes sense on several fronts, from asset-liability management, to collateral sourcing – including the repoing of high-quality assets – and sharing of expertise. Clearly, policy co-ordination is a difficult issue owing to areas of both synergy and diverging interest.
Where the management of Italy’s debt is concerned, especially in view of its size, every strategic decision is of consequence and should not be immune to public scrutiny. The Tesoro’s derivatives portfolio is comparable, in absolute size, to that of a bank market-maker, but structurally far more directional. This means it needs to develop comparable capabilities in terms of technical and operational expertise and risk management, as the cost of not doing so is just too high. Better disclosure and communication would help both public discourse and accountability.
Finally, institutional aspects and policy co-ordination need to be reviewed for synergies and conflicts of interest alike. In the end, looking at both explicit and implicit costs, the hard lesson is that a debt manager such as Italy cannot afford to be anything less than best-in-class among not just sovereigns but private sector market participants as well.
Footnotes
1. Italian debt held by the public is roughly €2 trillion. A change of just 0.1% in interest costs on such an amount is €2 billion, which is about double what the nation spends each year on poverty reduction.
2. According to analysis in “Regulatory Reform of OTC Derivatives and its Implications for Sovereign Debt Management Practices”, OECD (2011), only four out of 24 sampled countries had used swaptions from 1981 to 2010.
Stefania Perrucci is the founder and chief investment officer of New Sky Capital. Previously, she was global head of fixed income at Turner Investments, and portfolio manager at Morgan Stanley.
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