Downgrade fears push South Africa banks to join CCPs

FirstRand, Barclays Africa and Standard Bank eye direct LCH membership

South Africa: downgrade fears are prompting local banks to join CCPs

The looming threat of a downgrade to South Africa's sovereign credit rating has forced some of the country's largest banks to take radical action to ensure access to overseas central counterparties (CCPs), with some fearing that a cut to junk status would preclude international CCPs such as LCH from allowing them to onboard.

FirstRand, one of the country's largest banks, has joined LCH Ltd's SwapClear service via a newly created London-based markets entity, FirstRand Securities Ltd, which will allow it to clear trades on an intragroup basis. The firm became a member of the over-the-counter clearing service on July 25. The bank was planning to create the entity regardless, but the looming threat of a downgrade prompted it to accelerate its plans, says Stephen Linnell, Johannesburg-based chief operating officer of the bank's corporate and investment banking arm, RMB Global Markets.

"LCH have their own internal risk models that take into account an applicant's own creditworthiness, as well as sovereign and jurisdictional risk factors. If there was a further downgrade of South Africa's long-term foreign currency credit rating, and its causal factors [were] sensitive within LCH's internal models, that might jeopardise new South African members coming on to the platform. If one has however already achieved membership, the adverse effects of such a downgrade are likely to be less. This is, in fact, one of the driving motivations to achieve membership as soon as possible," says Linnell.

If a clearing member or its sovereign's credit rating does deteriorate, it is understood that LCH would not terminate that firm's membership, but that margin add-ons for the affected member would increase as credit quality declines.

South African legislators have insisted that CCPs that want to clear for local entities must maintain a legal presence within the country, despite most dealers expressing a firm preference to clear OTC derivatives at LCH. Most local banks already clear interbank hedge trades at LCH or rival CME Group as clients of other dealers. One local bank says 75% of its interbank hedge trades are with foreign dealers - most of which would likely clear those trades at LCH.

South African lawmakers are understood to have insisted on CCPs having a local presence to allow the domestic watchdogs to maintain some oversight in the event of a default by a local bank. Privately, market participants say such a presence will in reality amount to little more than "a PO Box address".

Several stumbling blocks remain, though, before CCPs can establish a presence in South Africa and begin offering clearing to local entities - not least the fact that no licensing regime to recognise foreign CCPs currently exists. Several pieces of legislation that will, collectively, provide this framework are currently working their way through South Africa's parliament, along with an amendment to the country's Insolvency Act.

Clearers are understood to have insisted on the latter amendment, with some fearing the country's law as it stands could interfere with a CCP's default management process in the event of a local dealer going bust.

"LCH and CME wanted to ensure that, in the event of an insolvency of a South African bank, their default management rules would apply without question," says a source familiar with the matter.

In an explanatory memo on the changes, the Treasury notes: "[T]he Insolvency Act protections are crucial to [a] CCP's ability to provide clearing services and to containing systemic risk in the event of default. This is true whether the CCP is domestic or foreign, and providing services to South African market participants. Consequently, amendments are being proposed to provide foreign CCPs the same protections as domestic rule-making market infrastructures. Accordingly the external CCP will have to have some local presence."

The legislative changes are expected to take effect before the end of this year, says Roy Havemann, Johannesburg-based chief director for financial markets and stability at South Africa's National Treasury.

"We're hopeful the CCP licensing will be live by the end of this year at the latest. We're hoping for sooner, but we're committed to the end of this year. LCH and other foreign CCPs would be free to apply for a licence from then on. Once the required changes to our Insolvency Act have been made, then we'll be able to set out how the clearing mandate will proceed," he says.

That timing wouldn't be an issue, were it not for the looming threat of a sovereign downgrade for South Africa. Standard & Poor's currently has a long-term foreign currency rating on South Africa of BBB-/A-3 - one notch above junk - with a negative outlook. Its next rating decision will be published no later than December 2, with many fearing the rating agency will downgrade South Africa to sub-investment grade status.

That date will likely fall before LCH can gain a licence and begin offering services to South African banks on a local basis - hence FirstRand's move.

Two of the country's other sizable lenders, Standard Bank and Barclays Africa, both confirm they believe they meet the conditions for membership at LCH, and would likely seek membership on a local entity basis once LCH has gained its licence. Both have, however, ruled out applying to join LCH via their London-based legal entities, with both having a less pressing need to do so than FirstRand.

Barclays Africa confirms it currently clears via Barclays in London, in effect as a client, while Standard Bank is understood to have a client clearing relationship with two banks that offer it access to international CCPs. The bank also has the fall-back option of clearing via ICBC Standard Bank, the London-based global markets business in which it sold a majority stake to Industrial and Commercial Bank of China last year.

"LCH cannot extend membership to South African entities until Europe's clearing regime is deemed equivalent to South Africa's - something that can't happen until after the promulgation of the Financial Markets Act. As such, whilst we meet the relevant criteria for LCH membership - we've passed our driving test and so forth - we cannot submit an application at this time," says Chris Edwards, head of prime services at Barclays Africa in Johannesburg.

When it does finally kick in, South Africa's approach to implementing its OTC clearing mandate will likely closely mirror that of Europe's, with market participants ordered to begin clearing in phases according to the size of their derivatives exposures. Dealers say they expect the first clearing mandate for house business to kick in roughly two years from now, with a client clearing mandate - likely more limited in scope than Europe's approach - to follow between three and five years from now.