Like much of the post-crisis regulatory framework, margin requirements for non-cleared derivatives were intended to respond directly to the counterparty risks that appeared in Western bilateral swaps markets in 2008, but they have been adopted by many major Asian jurisdictions as well. Local market participants could be forgiven for questioning whether the rules are entirely appropriate for them, since they now face the prospect of paying a penalty simply for being based in Asia.
Global banks, which have the liquidity to dominate trading with the buy side, extract an additional charge for accepting as margin any securities not denominated in the world’s biggest four currencies (G4) – US dollars, euros, UK sterling and Japanese yen. This means, for example, that posting collateral in Singapore dollars – as insurers with most of their assets in the city-state would want to do – is likely to be more costly than posting the same collateral in US dollars.
On the flip side, if derivatives users want to be able to post collateral in a non-G4 currency, they must also be prepared to accept non-G4 collateral in the event that the derivatives price moves in their favour. This represents an additional cost, since firms might not have the financial expertise or international footprint to make the best use of this non-standardised collateral in the same way as a global bank could.
The exact premium for posting non-G4 collateral varies by trade, currency and counterparty, but market participants say it can be significant. The use of non-G4 securities as collateral is also still relatively rare, making it harder to assess a fair price on any given trade.
Since September, all derivatives dealers in most of Asia’s main financial centres – including Australia, Japan, Singapore and Hong Kong – have been required to post variation margin against non-cleared trades. However, because of the relatively small amounts that have to be posted, this has mostly been done using cash.
Things will become much trickier once firms have to think about posting securities as collateral, as they may do once they have to face initial margin rules. Smaller firms, including buy-side players, have been able to escape requirements to post IM so far, but everyone will have to face these rules by 2020. Since the amount of collateral that needs to be posted under IM is likely to be more than under VM – and dealers will have to be prepared to tie up this collateral for the lifetime of the trade – those who have not switched to posting securities may face the problem of a cash drag on their portfolio, hitting returns.
As more and smaller buy-side firms fall into the scope of the non-cleared margin rules, the pain will spread and worsen.
We are still at the stage of margining of derivatives trades where the firms involved are very much the sophisticated ones – the ones that have large baskets of assetsIvan Nicora, Euroclear
“We are still at the stage of margining of derivatives trades where the firms involved are very much the sophisticated ones – the ones that have large baskets of assets,” says Ivan Nicora, Asia-Pacific head at Euroclear, a triparty collateral manager.
“As we go through the different phases [of margining], we will reach those entities that have more of a local or regional dimension, and portfolios that are likely to be more heavily weighted towards local and regional bonds. The question of eligible collateral will, for them, be far more important,” he adds.
For one large Asian buy-side firm, the cost of being able to post local collateral is the key determinant in deciding whether to execute a trade with a particular bank, as long as the bank in question can execute the required notional size of the trade. The head of derivatives at the firm says the cost of trades can vary by as much as four basis points between banks, which he describes as “significant”.
Much of this discrepancy can be accounted for by the different ways in which the banks are able to fund the non-standard collateral on their balance sheet and the extent to which they pass additional costs back to their clients.
“It depends on the market and [the] bank’s appetite to either absorb or pass the cost on to the client,” says one Asia-based regulatory expert for a US bank.
The cost of posting non-G4 collateral is largely dependent on the prevailing swap curve of the day, which goes some way to explaining why posting US Treasuries tends to be cheaper than posting most Asian government securities. But there are also other reasons why global banks charge a premium for accepting non-G4 collateral.
One key consideration for a bank that wants to accept collateral in a non-standard Asian currency is the extent to which doing so could expose them to correlation or wrong-way risk. For example, if a trade in Thai baht is collateralised using Thai government securities, when the value of this currency falls, the collateral will also devalue. This potentially adds to the credit valuation adjustment cost that banks face, although it remains an open question as to the extent to which wrong-way risk is being priced in at present.
Alexandre Bon, a senior solutions architect for trading technology vendor Murex, says this is why global banks have so far shied away from accepting collateral in these more niche currencies. Even where global banks are prepared to accept such collateral, they will charge such a premium as to make collateralising the trade in that currency unattractive. One Asian currency that global banks appear more willing to accept, despite the potential for wrong-way risk, is the Singapore dollar, and there have been some credit-support annexes (CSAs) signed with global banks recently that allow collateralisation of trades using this currency, says Bon.
Another reason why banks charge higher costs for accepting many Asian currencies as collateral, according to Yoram Layani, head of institutional sales in Asia for BNP Paribas, is that such securities cannot always be lent out easily in the relatively illiquid local repo markets. Consequently, they often end up sitting on the bank’s balance sheet, imposing a funding cost.
Unless the market is liquid, it is very hard for me to accept something as collateral, because I need to be able to get rid of it in times of stressA senior treasurer at one Asian bank
A better-developed repo market would help both the sell and buy side to comply with global margining rules, say banks.
“Unless the market is liquid, it is very hard for me to accept something as collateral, because I need to be able to get rid of it in times of stress. It’s not just about getting the local assets on to your book. It’s about being able to swap them into a liquid currency that is accepted worldwide,” says a senior treasurer at one Asian bank. “This is why I entreat the regulators to develop this type of market here, in order to improve liquidity and the proper functioning of all these regulations they are imposing on us.”
In the absence of deep and liquid repo markets, banks can also reduce the costs of accepting local collateral and hence the premium they charge their clients by finding creative uses for the assets. For example, in Hong Kong, Singapore’s OCBC is using the local government bonds it is taking on as client margin to help its subsidiary there meet liquidity coverage ratio requirements. The LCR requires banks to hold enough high-quality liquid assets that could be sold to meet funding needs during a 30-day stress scenario, and local government bonds would qualify as HQLA.
“Clients that have large amounts of Hong Kong government securities on their books want the convenience of being able to post these, rather than convert them to some other collateral type,” says Frederick Shen, head of the bank’s global treasury business management unit. “We try to be accommodating, but I need to make sure my subsidiary in Hong Kong can use the cash and government securities on its balance sheet. Beyond that, I will start charging.”
Bon from Murex thinks this is one of the reasons why banks with a large footprint across Asia will be able to price local collateral more competitively than one with a smaller regional deposit base.
“If you’re a local Singaporean player and you want to post Singapore dollars as collateral, then a Singapore bank counterparty may be at an advantage as they would be more comfortable funding in Singapore dollars. They would have a deposit base in the local currency, and are already active in the local currency repo and money markets,” he says.
Banks with large retail operations in the region, such as Citi or HSBC, might also be in a good position – although Bon could not say for certain whether they would be more likely to accept Asian currency than other global banks with a smaller regional deposit base.
Hedging and pricing
Additional funding charges could also be incurred if a bank tries to hedge the client deal out to another large bank, since the bank providing the hedge is likely to require margin in a major currency. “The cashflows won’t match,” says Luke Brereton, co-head of Standard Chartered’s clearing and intermediation service. “This can result in an additional spread charged to the client to account for the funding valuation adjustment.”
Backing trades with Asian collateral is further complicated by ineffective overnight index swap markets across the region, making it difficult for banks to understand how expensive it will be to fund a particular type of collateral on the balance sheet, and therefore how much they should be charging the client for this risk exposure.
Even in Singapore, where international banks are now starting to accept local collateral, the domestic Singapore Swap Offer Rate is based on a market that is too illiquid to provide an accurate indication of how much interest a bank should pay on top of the collateral they accept. As a result, many banks substitute this index for the more established London interbank offered rate, which creates a pricing mismatch and in many cases results in clients being charged more.
Local laws add to the cost. In China, global banks have been levying particularly heavy charges for accepting local collateral – which usually comprises renminbi government bonds, as the country has foreign exchange controls in place – because they are not allowed to rehypothecate the bonds. South Korea had the same issue until March, when a new law was passed allowing the reuse of government bonds for new CSAs. In India, collateral cannot be posted cross-border, so global banks have to sign local CSAs, underpinned by Indian rupee collateral, with their Indian counterparties.
Bon from Murex says all of these elements compound to make it more expensive for banks to accept currencies outside of the G4, but the cost faced by banks is not consistent across the board. It depends on how effectively the banks can make use of the collateral they accept, the way they price XVA and how well the collateral fits in with their legacy portfolio of existing CSAs. He predicts the pricing of collateral will become an important competitive dynamic in Asian markets.
“You will always get different prices with different banks and the variation will be potentially large, and it will be difficult [for clients] to understand where this price differential comes from,” says Bon. “Banks are trying to estimate what the other guys are going to charge and, in some cases, if they want to remain in a market, banks may have to swallow part of those costs if their competitors are not pricing in the same way.”
Thio Tse Chong, managing director of treasury and markets at Singapore-based DBS, suggests another solution for the buy side: since banks charge a premium for accepting non-G4 margin, buy-side firms should try to get hold of the right kind of collateral for posting.
“The buy side should consider using standardised, single-currency VM CSAs with trading counterparts to get transparent pricing and transform their ineligible assets for collateral posting via collateral transformation,” he says.
Thio says the most optimal solution would be for buy-side players to perform the collateral transformation themselves, but few of them in Asia are likely to have this capability.
The large Asia-based buy-side firm referenced at the start of this article has been looking at whether it makes sense to perform the collateral transformation itself, rather than accept the premium charged by banks, and the results are far from encouraging. The firm’s head of derivatives says that setting up and maintaining a collateral-transformation programme can be “operationally challenging” and the charge for doing a repo through the market – the repo rate – “can be hard to predict, depending on the [deal] size”.
He says banks can probably transform collateral in a more cost-effective way as they have the relevant expertise, systems and network. Banks can monitor securities prices throughout the day and swap their assets in the market when the price is right.
The alternative, says Chong, would be to use the third-party collateral-transformation services that most banks offer to get hold of the right kind of collateral – although this comes at a price.
Ajay Chavda, a senior over-the-counter consultant at large Australian investment manager AMP Capital, says it is imperative the buy side starts thinking now about what collateral they have on their books.
“Good-quality collateral is only going to become more expensive, so it is very important to start early to transform the collateral you are going to need to post,” he says. “If you have a good stock of these instruments now, you are less likely to be scrambling around later when there is a scarcity.”
Good-quality collateral is only going to become more expensive, so it is very important to start early to transform the collateral you are going to need to postAjay Chavda, AMP Capital
But, for many buy-side firms, substantial collateral transformation may not be an option. They are likely to be restricted in the type of assets they can hold on their books and the amount of counterparty risk they can take on through the repo market, says Brereton of Standard Chartered. For example, a pension fund may be required to match local currency liabilities with local currency assets and keep the total assets it holds in foreign currencies below a certain threshold.
The currency premium faced by Asian asset managers in margining their trades comes on top of what a recent global survey of buy-side firms describes as the “pressing concern” of access to high-quality collateral, funding and liquidity.
The authors of the survey – commissioned by Bank of New York Mellon and entitled ‘Collateral: The New Performance Driver’ – suggested difficulties collateralising trades may have far-reaching consequences, to the point of forcing insurers to change their business models and the products they are willing to offer.
Insurance companies reported they were worried about their ability to continue sourcing the necessary assets to cover their exposures, especially in times of market stress.
“These concerns are forcing insurance companies to review their product mix and develop/offer variable [rather than fixed] annuity products that can pass interest rate risks directly to customers, instead of attempting to hedge these risks internally,” the authors of the survey wrote. “If this situation materialises, it would affect the important risk-sharing services that insurance companies provide to the economy.”