Regulators move to limit derivatives-supported debt in Asia

Back to basis

amit-agarwal

After an extended period of volatility during the global financial crisis, when the evaporation of US dollar liquidity drove the Asian foreign exchange basis into positive territory, the subsequent deluge of dollars into the region during the past two years has reversed the trend, sending the basis swap into negative territory in most cases and limiting volatility.

“The premium associated with dollar scarcity has significantly reduced as a result of global policy measures and the flow of private dollars into the region,” says Amit Agarwal, managing director and head of fixed income structuring for Asia at Barclays Capital in Hong Kong. “We have seen some mean reversion in Asian forex basis with both basis spreads and volatility falling. Bid-offer spreads too have tightened to reflect this more normalized environment.”

The normalisation trend has been more pronounced in currencies that have demonstrated greater historical price stability versus the dollar and which had little basis spread to three-month US dollar London interbank offered rate (libor) prior to the crisis. For example, the cost of swapping principal and interest paying three-month Hong Kong interbank offered rate (hibor) cash flows into three-month US dollar libor for five years has traded in a range between minus 15-20 basis points for the past two years, while the cost of exchanging three-month Singapore interbank offered rate (sibor) for the respective US dollar fixing for the same tenor has stood at around minus 20-25bp.

Although the cross-currency basis has narrowed for local currencies across the region, it remains comparatively wide and volatile in markets that suffer from a relative shortage of US dollars such as the Indian rupee, won and ringgit. Dealers say that, of the liquid basis markets, the five-year US dollar/won basis swap remains the widest at around minus 100-150 basis points and most volatile, characteristics that are amplified in the 10-year tenor.

Furthermore, the imposition of capital controls in these countries will likely further limit dollar availability, a factor that could keep basis swaps in these markets wider than the regional average.

Optimising funding costs
Pointing to the recent growth in the volume of foreign currency debt issued by Asian, particularly South Korean, corporates, dealers say the renewed focus on after-swap funding levels and liquidity management is driving greater usage of the cross-currency basis as a funding and liquidity management tool: “Asian corporates are focusing more on extending their funding curves and maintaining strong liquidity for the most active tenor buckets. We are seeing more corporates employing derivatives to help both reduce the cost of funding and create the funding they need on their balance sheets,” says Alvaro Patron, co-head of corporate derivatives structuring and sales at Citi in Singapore. The strategy mimics the approach of Asian quasi-sovereign borrowers and Australian double-A rated banks, which, prior to the crisis, had become frequent users of cross-currency basis markets to achieve favourable all-in funding terms.

Issuance of non-won denominated bonds by Korean corporates has grown rapidly since 2008, reaching $15.4billion in 2010, according to analysis from capital markets data provider Dealogic. So far this year, Korean corporates have already issued $11.2 billion of non-won denominated debt, with US dollars accounting for $8.8 billion or almost 80% of the flow. Corporate issuance so far this year, accounts for a similar proportion of the non-sovereign market with financial institutions contributing the remaining 20%, according to Dealogic.

Although the lack of OTC swaps data makes it hard to estimate the size of the basis swap hedging market, dealers strongly suggest that many Asian corporates are taking advantage of historically low dollar rates and tighter cross-currency basis swap spreads to access cheaper won funding than might be achievable in local bond markets.

The tightening bias across Asian central banks, with India, Malaysia and Philippines all raising rates in May, is driving interest costs for corporates with existing floating rate term loans or working capital loans on their balance sheets significantly higher. The monetary environment has therefore raised the incentive for treasury managers to lock-in the relatively more attractive cost of funds available today with fixed-rate term loans or bond issuance: “Access to such fixed-rate loans is being obtained by either the standard bond plus swap format, or via cross-currency swap basis in Asian markets where it provides opportunity,” says Christopher Chan, Asia head of corporate rates sales at Deutsche Bank in Singapore.

Derek Awyoung, co-head of corporate derivatives sales with Patron at Citi in Singapore, says that higher levels of dollar debt swapping in the basis swap markets is itself driving the risk premium lower: “We have seen the USD/KRW basis narrow over the last six months in line with increased bond-plus-swap funding activity from Korean corporates. The swap level has gradually traded tighter from around minus 150bp to minus 100bp on the back of very strong issuance levels,” Awyoung says.

With a narrower basis and reduced volatility in both five and 10-year US dollar/won basis markets, dealers say corporates have extended the tenor of their hedging activity. “Reductions in both basis spreads and volatility from the crisis period allows both investors and hedgers easier access to longer dated products... the narrowing of bid/offer spreads at the long end is also supportive of this trend,” says Barclays Capital’s Agarwal.

The won negative basis has also attracted significant interest on the asset side, with a range of institutional investors, especially foreign bank treasuries, exploiting their access to cheap dollar funding to use the basis to source won assets onshore at relatively attractive levels.

“Investors like bank treasuries and insurance companies who are looking to source instruments onshore have limited opportunities in terms of liquidity, tenor and relative value. Swapping cheap dollar funds into won allows these buyers to widen the range of investment options, as well increase total yield to the extent of the basis between the dollar and won cost of funds,” explains an interest rates salesperson based in Singapore.

While dealers familiar with the market say that most buyers timed negative basis trades to take advantage of market wides, investors with particularly cheap dollar funding have remained in the market on an opportunistic basis.

However, the willingness of both foreign banks and Korean corporates to use derivatives markets to exploit the availability of cheap dollar funding has not gone unnoticed by regulators. A regulatory panel including the Bank of Korea, the Ministry of Strategy and Finance, the Financial Supervisory Service and the Financial Supervisory Commission recently probed the currency derivatives activities of foreign banks and concluded that the increase in dollar-funded debt concentrations presented a systemic risk, should the availability of onshore dollar liquidity become constrained. The panel announced a new rule lowering the ceiling on banks’ forex forwards by 20% on May 19.

“The ceiling on the foreign exchange forward position by local branches of foreign banks will be cut to 200% of their capital from 250%, while the ceiling for domestic banks to 40% from 50%,” the Council for Foreign Exchange Policy said in a statement. Moreover, Korean regulators are also considering limiting the supply of foreign currency debt from domestic corporates, so called ‘kimchi-bonds’, following the sharp growth in issuance this year.

“Banks, especially foreign bank branches that can get cheaper US dollar funding used their resources for two main purposes: to fund for exporter clients’ forward US dollar sales and bond-swap basis trades,” says a Hong Kong-based interest rates trader familiar with the situation. “The purpose of the regulation was to limit relative value basis trades, which caused market disruption when dollar funding became difficult and positions were unwound at once.”

Dealers say that, because the market was aware of the investigation and the national pre-occupation with vulnerability to global dollar liquidity conditions, most positions had already been wound down in expectation of the move by regulators. However, reduced capacity in the forex forward markets could undermine overall activity and liquidity in the cross-currency basis markets. “We might see an increase in onshore forex versus offshore NDF [non-deliverable forward] basis activity specially during times of market stress,” the trader says.

Limiting the basis
The focus on basis risk among Asian corporate treasurers and CFOs extends beyond the use of cross-currency basis swaps in funding arbitrage. Indeed, the growth of five and 10-year basis swap markets in Korea is part of a more general move away from the use of short-dated hedging strategies.

“In terms of tenors, clients were typically putting on short-dated hedges and rolling them on a periodic basis rather then putting on a long-dated or term hedge to match the tenor of the underlying,” says Deutsche Bank’s Chan.

“We have seen a major shift in the mindset of Asian corporate treasurers and CFOs, whereby for any long-term underlying forex exposure, they are looking for hedges to maturity,” says Chan.

At the same time, the pressure on corporates to ensure all derivatives used for hedging are hedge-accounting compliant has limited demand for short-dated forwards as a tool for managing longer-term basis risks. “Corporates are under intense pressure for hedges to be accounting friendly, which limits the use of short-term proxy hedges that don’t match one-for-one the risks they are hedging. Consequently corporates tend to prefer hedging solutions that reduce their exposure to basis risk. But this can increase the cost of hedging,” says Citi’s Patron.

Dealers point to a range of hedging tools designed to mitigate the major basis risks confronting corporate treasurers. For example, modifications to cross-currency basis swap contracts can allow debt issuers to tailor basis risk exposure to a specific market view. Giving corporate bond issuers the option to reset the basis swap spread at some point in the future allows risk managers to hedge today’s rate while providing an opportunity to benefit from future spread narrowing to reduce ultimate funding costs.

Similarly, dealers are offering ‘flexi-basis swaps’ to borrowers that allow them to lock-in attractive basis swap spreads to support debt issuance in the future. “Flexi-basis swaps allow issuer clients to market debt without worrying about basis risk. The product is relatively inexpensive way for users to lock in a rate today with the flexibility to make the swap effective when the issue launches. This allows them to focus their marketing efforts on the quantum of debt that can be placed,” says Joyce Tam, a director within the fixed income group at BNP Paribas in Hong Kong.
In addition to cross-currency basis management, users are looking at other ways to stay on top of basis risk, especially approaches that enable them to link hedging products to reduced earnings volatility. For instance, corporates have made increased use of local currency invoicing and local fixing rates to avoid the premiums charged by suppliers to hedge G10 currency exposures.

Asian suppliers tend to bear the forex hedging risk for receivables invoiced in G10 currencies and pass the cost onto their customers in the form of a risk management premium that might be as high as 15%. By switching to local currency invoicing, buyers take on the cost of hedging, which dealers say is usually much more cost effective than the supplier’s risk management premium. However, local currency markets can suffer from poor transparency with respect to fixing rates, potentially increasing basis risk in a local forex hedge.

“We’re seeing many corporates shifting to local currency invoicing for both their inter-company and third party flows,” says Deutsche Bank’s head of multi-national corporate treasury sales for Asia, Gautam Hazarika. “We also combine this solution
for clients dealing outside Asia with transparent forex rates based on fixings, typically difficult to do in most Asian markets.”

The launch of onshore currency derivatives markets in China means that local corporates now have access to products that should help them minimise the basis risks associated with currency and interest rate hedging. In theory, onshore markets should bring local corporates the benefits of better liquidity, more efficient forward-curve pricing and less basis risk. Furthermore, with both underlying risk and hedge sourced in local markets, the task of producing the documentary proof of underlying transactions should be relatively simple. Already, dealers say they have enjoyed significant success in reducing hedging rates and basis risks in onshore markets.

For disheartened corporates facing volatile derivatives markets, where the availability of products may not adequately match the underlying risks in their commercial operations, the prospect of changes to International Accounting Standard (IAS) 39 may encourage some to reconsider their approach to the market. The proposed new rule, International Financial Reporting Standard 9 (IFRS 9), which would relax rules requiring hedgers to value options on a mark-to-market basis, could afford corporates a wider opportunity set to design hedges that work for the exposures they have.

On what basis?
Basis risk is a concept that applies to a wide range of derivative markets, and refers to the idea that offsetting positions in a hedging strategy will not experience price changes in exactly opposite directions from each other. In this sense, the basis represents the difference between the theoretical value of a hedge and the actual market-traded value.

The largest and most widely traded form of basis is cross-currency basis, or the difference between the floating interest rate fixing offered by one currency and the floating interest rate fixing offered by a second currency for a specific term.

The cross-currency basis swap market allows users to exchange principal and interest in one currency for principal and interest in a second currency, typically as a way of hedging funding costs in the original currency. While cross-currency basis had historically been viewed as correlated to the interbank lending market with little or no basis between markets with ample liquidity, the global financial crisis
introduced a new awareness of the factors that drive the basis.

“The scarcity of dollars in a local market has traditionally been viewed as the main driver of cross-currency basis in Asian markets. But since the crisis, markets are also increasingly focused on capital requirements, regulatory changes and credit conditions in the banking system as a whole,” says Amit Agarwal, managing director and head of fixed income structuring for Asia at Barclays Capital in Hong Kong.

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