Portuguese debt office agrees to post collateral to its dealers

Agency becomes one of first developed-market sovereigns to succumb to dealer pressure as costs of one-way collateral postings grow

The Portuguese debt office is set to become one of the first big sovereign derivatives users to bow to dealer pressure and agree to two-way collateral postings. The change means the Instituto de Gestão da Tesouraria e do Crédito Público (IGCP) will begin posting assets to its counterparties when the value of a trade swings against it, to mitigate the risk the debt office might default. It also means confronting a series of thorny problems that few of its peers have tackled – most notably, finding acceptable assets to post.

"We are still under our previous agreements, which are not two-way, but we are working on it. We have 18 primary dealers and we'll sign two-way agreements with all of them if they show an interest. But there's a lot of documentation to be changed, a lot of things that have to be clarified," says Alberto Soares, chairman of the IGCP.

Most sovereign entities – central banks, debt offices and others – insist banks post collateral when the present value of a trade is in the sovereign's favour, while refusing to reciprocate if the value swings back the other way – a one-way agreement that insulates the sovereign against the risk of a dealer collapsing, but leaves its counterparty with capital and funding costs. Those costs have grown during the crisis and will be hiked further when new regulations are implemented. As such, banks want sovereigns to sign two-way agreements – or to use central clearing counterparties (CCP), which would have the same effect.

"Obviously, people are apprehensive of one-way collateralisation and are aware of the costs involved. But things are going to get even worse and the rational thing is to try passing these costs to your counterparties, and they can then choose to amend their credit support annexes (CSAs) to two-way agreements or alternatively to start using a clearer," says a senior New York-based trader at one European bank.

Sovereigns and dealers alike believe other debt offices, central banks, local governments and supranationals will eventually do one or the other, rather than accept increased costs – but it's a bitter pill to swallow. Switching to a two-way version of the CSA – which sets out the terms for collateralisation – means sovereigns face a potential drain on liquidity. It also comes with accounting and operational challenges.

We are still under our previous agreements, which are not two-way, but we are working on it. We have 18 primary dealers and we'll sign two-way agreements with all of them, if they show an interest

The final insult is the argument that two-way CSAs open up about what collateral is acceptable to dealers and clearers: regardless of a sovereign's creditworthiness, taking its own debt to cover a potential derivatives default is a risk management no-no.

"You can't write me an IOU to cover your own credit," says John Wilson, global head of over-the-counter clearing at Royal Bank of Scotland in London. There are alternatives, like cash or other sovereign bonds, but none is straightforward, he says.

Some sovereigns have suggested a way round the impasse, says Wilson – their idea is that a group of them could exchange debt with each other and post that to a CCP. In Wilson's example, Germany swaps its bonds with Austria, Austria with the Netherlands, and the Netherlands with Germany, allowing the Germans to post Dutch debt as collateral.

It seems an elegant solution – until it is examined more closely. Not only would the bonds of one eurozone sovereign suffer in any scenario that caused another eurozone sovereign to default on its derivatives obligations, but all of the bonds would also be tied to the success of the euro.

The correlation makes many observers uneasy, but one senior futures industry executive in the US argues a line has to be drawn somewhere if the system is to work at all. "If you take that to its logical extreme, people would only be allowed to post gold – and we're not going there. At some point, you just have to accept some level of G-7 sovereign counterparty risk," he says.

Soares insists the IGCP has not been backed into a corner, denying dealers have threatened to raise their prices and saying none has refused to trade with the debt office on a one-way CSA. Instead, the office's decision was based on the expectation prices might increase in future, he says. "It is a process – it's not black or white – it's a process where we have to take into consideration different views."

When asked whether dealers will accept Portuguese government bonds as collateral,
Soares bristles: "Why not?". As things stand, he says, the debt office is planning to post either its own bonds or cash as collateral. Will dealers accept the bonds? "You'll have to ask them," he says.

The August issue of Risk magazine will carry a feature looking in more detail at the issues around sovereign clients and the use of collateral and clearing.