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Monday, 18 December 2017

Collateral damage

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Supranationals are stubbornly resisting calls to post collateral on swaps, but bankers warn they may pay a high price for their defiance if they drift down the credit curve to find swaps counterparties.

To see the digital version of this report, please click here.

When UBS marched out of the SSA sector in October jabbing its finger at “inflexible” supranationals, it threw into dramatic relief pressures on issuers to post collateral on swaps.

The move left a bitter taste as DCM bankers watched yet another cohort of colleagues pack up their things, and syndicate desks duly warned that borrowers would have to rethink asymmetric swap arrangements based on one-way credit support annexes.

A collateral shift amounts to a cultural change among SSA derivatives users that have traditionally enjoyed one-way CSAs – contracts that require banks to post collateral to them when out-of-the-money on swaps, while not receiving it when the situation is reversed.

Bankers’ frustration at this asymmetry has often been directed at the European Investment Bank – Europe’s largest supranational which has stubbornly refused to sign two-way CSAs. But dealers say clear blue water is opening up between the agencies and sovereigns on one side and the supranationals that still refuse to budge on the other.

Bill Northfield, head of SSA at Deutsche Bank, said: “The European agency community has worked closely with the banking community to understand the value of balanced liquidity and risk management practice via two-way CSAs, and this co-operation is much appreciated by the markets.”

Unwelcome stigma

Bankers are now asking why the supras – not only the EIB – continue to drag their feet and attach a stigma to two-way CSAs that discourages smaller players from committing.

One senior European banker said: “Maybe anger is too strong a word – but there is a lot of frustration among the banks that one group of fairly similar issuers have found it very easy to change, and another group has said it’s just not possible. One is being slightly disingenuous.”

The EIB also raised the stakes in February by signalling that it aims to upsize its US dollar funding programme, requiring its banks to swallow punitive costs on long-dated cross-currency swaps.

A senior DCM banker in London said: “Some supranationals are definitely more ready to look at two-ways whereas others are more reticent. It’s a bit unfair just to put the EIB into that camp – it’s there alongside others. Clearly the EIB has a very big funding programme and big outstandings which makes it more difficult for them to effectively contemplate this. But certainly, for the time being, they are not actively engaging with the banks in terms of two-ways.”

“I would still urge all issuers to move towards a two-way CSA to keep the market robust and to keep the banks wanting to invest in the market going forward”

Industry groups have repeatedly called on the sovereigns to act on collateral and optimists say it is only a matter of time before the EIB buckles because of a shrinking pool of counterparties that are willing to swallow the swaps costs. But the pessimistic majority view is that the shock UBS move has changed little.

One SSA banker said: “It was very ugly. It has somewhat focused the minds of a number of the one-way CSA issuers, however, I don’t sense it’s moved anyone like the World Bank, the EIB, or others any closer. They are still digging in their heels.”

Intensified pain

Moreover, the pain has intensified. Because most CSAs are based on overnight cash or three-month Libor and those rates have come down, most banks are now posting collateral to the EIB and getting a negative funding rate on top of it.

Sean Taor, head of European DCM at RBC Capital Markets, said: “I have some sympathy for the issuers: if they are getting good quality pricing from a wide range of banks then why change when doing so will potentially lower their revenue? Their reluctance is more often based on pure economics, however, it’s a short-term gain – and we all would agree that we need a strong market for years ahead. I would still urge all issuers to move towards a two-way CSA to keep the market robust and to keep the banks wanting to invest in the market going forward.”

Sovereigns and agencies use interest rate and cross-currency swaps to manage their liability risks, but most tend not to be heavily reliant on them. Agencies and supranationals are larger users, needing to swap most of their primary issues and using cross-currency swaps to tap foreign markets. The market is crucial for players that manage an asset-liability portfolio that have a floating rate as a benchmark and on-lend on a floating basis, like the EIB or Germany’s KfW.

As the landscape has been transformed by the eurozone crisis, two-way CSAs have started to appear, especially among issuers that fear a lock-out.  Portugal’s Instituto de Gestao da Tesouraria e do Credito Publico switched in July 2010 and Ireland’s National Treasury Management Agency  was forced to sign bilateral CSAs in 2011.

An important landmark occurred last June when in a policy U-turn the Bank of England said that it was reverting to two-way CSAs for raw value-for-money reasons. Hungary and Sweden already post two-way CSAs, while recent converts include the Danish and Latvian DMOs.

Asymmetric contracts

Many agencies have also tweaked CSAs. Heavy derivatives user KfW now posts collateral (albeit its own bonds). Elsewhere, BNG, the Dutch public agency, and  OeKB, the Austrian export credit agency, have moved to two-ways, while the UK’s Network Rail signalled late last year it will do so. There has even been some movement by supranationals in the form of the Nordic Investment Bank.

One-way CSAs are a legacy of the pre-crisis era when capital was cheap. While there are many components to the charges that apply under a swap, operating under these asymmetric contracts shoulders dealers with a weighty burden of internal funding, credit and regulated capital charges in the post-crisis world.

A bank generally hedges swaps with sovereigns by conducting an offsetting trade with an interbank counterparty, and must still post collateral to its hedge counterparty. In the new regulatory climate, hedging costs are compounded by the credit and capital charges enforced under Basel III.

Having built up large, long-dated swaps portfolios governed by one-way CSAs before the 2008 crisis, many dealers now find themselves weighed down by eye-watering capital and funding charges attached to these trades in the brave new world.

Signing two-way CSAs is no panacea for dealers, as the new contracts are unlikely to completely remove inequalities in the relationship. Borrowers that have agreed to two-ways have still insisted on asymmetrical thresholds, where the triggers or posting requirements are different for each side – normally in favour of the higher-rated party, namely the clients.

But SSAs posting collateral would resolve a lot of the issues for dealers in terms of reducing capital and funding costs, and so they have turned up the volume in their efforts to convince public sector clients to change their CSAs by edging up quotes on swaps. There have also been notable efforts to unwind exposures or dispose of them to other banks: in the most famous example, Morgan Stanley reduced its exposure to Italy from US$4.9bn to US$1.5bn by restructuring certain derivatives with the sovereign.

RBC’s Taor said: “If you look back three or four years you’d find that the only difference in swap pricing was really around how aggressive or timid a swap counterpart would be in regard to execution; there was a funding charge but the capital element around the credit exposure was not an issue – which explains why the legacy portfolio at UBS and other banks is now so painful. But now I think there is much greater understanding across all banks as to what the charges actually are, how to calculate them and the models they should use. The intellectual playing field is a lot more level.”

Reluctant to change

There are several reasons why SSAs are reluctant to give up their prized one-way CSAs. The most obvious is economic: by keeping with the status quo they are maximising PnL, still see competitive pricing from a wider range of counterparts, and can rightly claim that, UBS aside, others have remained active in the market.

Moreover, shifting to two-way CSAs poses new operational costs for sovereigns –  they have to invest in systems and the human capital needed to oversee collateral posting.

At the same time, sovereigns and agencies also suffer political drag, because signing two-way CSAs has implications for debt. Countries such as Latvia and Cyprus have been particularly exercised about the impact of posting collateral on debt, and cash collateral posted to DMOs and other sovereign entities is technically a loan that must be included in debt accounts.

“I do have sympathy for sovereigns. It’s clearly much harder for them [to move to two-way CSAs] because they will need ministerial approval and it’s very hard for anyone to sell to a government the idea that they should work towards helping banks”

But above all, the prospect of incurring a huge potential liability relating to collateral posting is hardly appetising. Most of these participants receive fixed payments in their interest-rate swaps, making them in-the-money on the trades in this low-rates environment. Once rates begin to rise and the swaps move out-of- the-money for them, large supras could have to post billions of dollars in collateral to their banking counterparties.

Understandably, few are thrilled with the idea of having to issue more debt in order to fund future margin calls and mitigate this liquidity risk.

RBC’s Taor said: “I do have sympathy for sovereigns. It’s clearly much harder for them [to move to two-way CSAs] because they will need ministerial approval and it’s very hard for anyone to sell to a government the idea that they should work towards helping banks, when political blame is being pointed at the banking system, and that rhetoric seems to be getting louder.”

Shopping around

A lack of consistency in swaps pricing across the banking sector is also encouraging SSAs to drag their feet. This is partly due to less sophisticated derivatives dealers playing catch-up in terms of factoring in capital and funding costs, which forms part of a blurry transition period in which competition between banks has meant that some continue to ignore costs to woo clients, allowing SSAs to shop around. 

A head of DCM said: “The banks are in a very competitive environment; some are subsidising the business, others are not – but I doubt this is a viable long-term solution. Swaps pricing is increasing slowly and we are getting closer to quoting on a true value rather than a full subsidy.”

For the time being, supranationals may be happy to go to second or third-tier derivatives dealers for their swaps. But bankers say there is a dwindling group of dealers that are willing to subsidise their clients’ swaps activity, while others are reaching risk limits with their counterparties. Moreover, many DCM participants are now raising concern around concentration risk as issuers drift down the line from better capitalised banks, taking more credit risk.

Some bankers even imply that, by moving down the credit curve, supranationals are swimming against the entire current of post-Lehman reform.

A head of DCM said: “In the end they will start to go out and use weaker counterparts, the big banks lose market share, and we all fight to try and find the right balance between catching up and how we price business. It is a negative spiral for all parties.”

But unless another major player withdraws in a UBS-style hissy fit, the tug-of-war between dealers and clients seems unlikely to end any time soon. Indeed, the lack of movement on collateral may even raise more profound questions about the supras’ responsibility to promote best practice.

One SSA banker said: “Incredibly, two years ago someone at one of the supranationals said to me: ‘We feel concerned that the next time there’s a crisis all the banks won’t have any liquidity – because we’re sitting on it. It would be far better to return that to the system rather than have the system collapse’.”

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