More sovereigns edge towards two-way CSAs - and clearing

The vast majority of over-the-counter trades will be cleared or collateralised in future – but sovereign derivatives users have been digging their heels in, generating increasingly painful funding and capital obligations for dealers. Quietly, though, some progress is being made. By Matt Cameron

On the face of it, dealers have had little success persuading sovereign derivatives users to sign two-way collateral agreements. The Cypriot, Danish and Latvian debt offices all say they are considering it – which would bring them in line with their counterparts in Hungary, Ireland, Portugal and Sweden. But of that group, only Portugal and Ireland made the switch in the past two years, and the world’s biggest sovereigns remain staunchly opposed to the practice – a policy that leaves their dealers facing capital and funding burdens.

Behind the scenes, though, there are signs of a thaw – a number of heavyweights now concede change is inevitable, and some are exploring the idea of central clearing instead of signing the two-way credit support annexes (CSAs) that govern bilateral collateralisation. Many sovereigns currently post no collateral, leaving dealers exposed to counterparty risk and associated capital charges – while others use one-way CSAs, which add funding costs to the burden.

“Central clearing would make life easier for us,” says the head of one of Europe’s biggest debt offices. “At the moment, we have an abundance of counterparties, so we have to do in-depth risk assessments for every one of them. If we were able to cut them down to just two or three clearing firms it would make life a lot easier. Yes, we might have to provide collateral, but from a purely economic perspective the swaps would also be cheaper. That said, this issue is very political. One of my obligations is to ensure our process is as efficient as possible, so central clearing is preferable. But I think there would be some very difficult discussions with the government. This will not be an easy argument to win.”

Central banks are also considering clearing, despite lobbying for, and receiving, an exemption from the European Market Infrastructure Regulation (Emir) that introduces mandatory central clearing and reporting of over-the-counter derivatives. Three dealers say the European Central Bank (ECB) sent out a request-for-proposal in the third quarter of last year to a number of banks that offer client clearing services. The ECB is also understood to have set up an internal working group to study how clearing might work for a central bank, but declined to comment for this article, claiming the issue is too close to its controversial location policy on clearing houses, which is the subject of a legal challenge from the UK Treasury (Risk January 2012, pages 14–18).

Two other European central banks confirm discussions are happening at the ECB level – and Ondrej Stradal, head of foreign exchange reserves management at the Česká Národní Banka, the Czech national bank in Prague, says while some of the practicalities remain vague, using a central counterparty (CCP) would reduce the operational burden involved in collateralisation.

“We already have two-way CSAs, and we are gathering information about central clearing, figuring out whether market forces are going to take us down this road. As yet, we haven’t felt compelled to decide to centrally clear, and we’re not sure how it would all work. But if, in theory, we were to centrally clear, it would actually benefit us from an operational perspective, because we are currently having to deal with multiple collateral flows every day. Whereas if we used one or two clearing members or joined a CCP directly, we would only have one or two collateral flows,” he says.

As with two-way collateralisation, the Riksgälden, the Swedish debt management office (DMO), is ahead of the curve – last year, it took part in a pilot interest rate swap clearing service offered by Nasdaq OMX in Stockholm (Risk March 2011, page 9).

The ECB started to explore this territory in a recent paper detailing five standards for central banks accessing CCPs either directly as a member of the clearing house, or indirectly as a client of a member bank. It states that the Eurosystem – the ECB plus the central banks of the eurozone countries – could use CCPs for interest rate swaps traded in the context of foreign reserve operations, and adds that even though central banks are exempt from mandatory clearing, they could decide to clear voluntarily to benefit from liquidity efficiency where trading is concentrated in market segments served by CCPs.

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