Friday, 18 January 2019

Difficult journey

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The tug-of-war between dealers and their sovereign clients over the posting of collateral relating to swaps exposures has entered a constructive new phase but with some banks stepping in with aggressive strategies, a solution is not yet guaranteed.

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There are signs that some supranationals and agencies are moving closer to signing two-way credit support annexes (CSAs), as a combination of impending regulation and the eurozone crisis has intensified pressure on these participants to post collateral against swaps exposures.

The majority of SSA borrowers currently have one-way CSAs, whereby they receive collateral when in-the-money on a swap with a dealer, but do not post when out-the-money. Such exposures leave dealers with several charges under Basel III regulations, which start being implemented from 2013, and which all global banks are introducing into their modelling now.

Until late last year dealers were forced to swallow the costs to ensure they retain the swaps derivatives business of some SSA clients, but the sovereign crisis and regulatory reform has forced banks to make some unpopular decisions and start passing costs on.

Basel III introduces credit valuation adjustments (CVAs) which require banks to hold more capital for counterparty risk. A report by McKinsey last year stated that the market risk framework would result in the current counterparty credit risk charge increasing by a factor of 2.5, driven by the CVA charges.

The extra cost burden is exacerbated by the fact that under Basel III banks will be forced to use price CVA based on the value of a counterparty’s credit default swaps and for a big agency issuer such as the European Investment Bank, the best proxy is European sovereign CDS, which quadrupled during 2011. The relationship between the CVA and CDS has been dubbed the CVA feedback loop.

Fever pitch forces action

These factors have made the status quo unsustainable, and, in some cases forced action as the European sovereign debt crisis reached fever pitch. During 2011, Portugal and Ireland were forced to sign bilateral collateral agreements after some banks refused to trade swaps with them on an unsecured basis.

Ulrik Ross, global head of public sector DCM at HSBC, said: “In the last 12 months there has been an active dialogue between banks and issuers and we have all tried to work on a solution. We have seen changes in pricing, changes in models, and changes in market participants.” 

Banks have challenged their clients to start posting collateral, or start paying the costs. The result has been a repricing of transactions that is so far being understood by the biggest borrowers but not by others.

Ross added: “It is no secret that banks are starting to pass on the fees they would incur under Basel III back to their clients, in the form of a CVA charge and a liquidity charge. Some issuers are accepting the higher price and others are focusing on solving for a CSA solution.”

The introduction of fees has had minimal impact on dealer revenues, according to bankers. One said: “The swaps business is still strong for dealers, the only change is that the top tier sometimes miss business where they did not before.”

Another top tier player added: “We see it as a fair price for quality business. We are not making any more money or keeping the fees, we have roughly the same business revenues.”

Dialogue over fees

The dialogue over fees is constructive because it comes against a backdrop of intense sovereign volatility. The European Central Bank’s provision of three-year cheap loans through its Long-Term Refinancing Operation did much to stabilise markets during the first quarter, but has not proved to be a panacea for the eurozone’s more troubled sovereigns. With yields on Spanish government debt rising following a failed auction this month, market participants are acutely aware that access to liquidity is vital and they are prepared to pay for it.

Passing on their costs to clients is a staging post in a journey which dealers believe will end in the introduction of two-way CSAs for all of their SSA clients.

“We would very much welcome two-way CSAs but in order to get there we have to go through a transition period where banks are pricing the charges differently. We are morphing slowly into a new regime of two-way CSA. Some agencies are doing it, supras are strongly contemplating it but the majority of sovereigns are still not posting collateral,” said Ross.

“We are morphing slowly into a new regime of two-way CSA. Some agencies are doing it, supras are strongly contemplating it but the majority of sovereigns are still not posting collateral”

The Cypriot, Danish and Latvian debt offices are the latest to say they are considering signing two-way CSAs, putting them in the same category as their counterparts in Hungary, Ireland, Portugal and Sweden. But the world’s biggest sovereigns so far remain opposed to the practice. In the current environment, where access to liquidity is more important than price to issuers, sovereigns would rather take a charge than post collateral.

There is another development that is holding the process up and that is the spectre of increased competition as some issuers that balk at paying increased fees start to shop around. LTRO and the symbiotic relationship it has created between some local banks and their sovereigns has had unintended consequences.

One banker said: “Some issuers are shopping around a bit, while more banks are entering the market, and what we are seeing is that some second and third tier banks are not adopting this approach and they are pricing aggressively as if Basel III did not exist. This is not a sensible strategy and it is not helpful but it is slowing down the move towards two-ways CSAs.”

“Whatever way you look at it, the market is changing. The dialogue is real and it is happening”

Agencies and supras are far larger users of swaps than sovereigns, needing to swap all of their primary issues as well as using cross-currency swaps to tap foreign markets and they are proving to be the most price-sensitive.

The biggest charge on these swaps is on credit rather than funding (which tends to be the main cost for sovereigns issuers). This is because funding charges only kick in when SSAs are out-the-money on swaps. Agencies and supras typically receive fixed, making them in-the-money on swaps in this low rates environment.

The European Commission is considering reforms to central clearing through the European Market Infrastructure regulation, and there are many unresolved issues which would deter some SSAs from jumping the gun and adopting CSAs.

The issue will reach crunch point soon. The latest raft of amendments to European proposals on bank capital means that trades with non-financials would be exempt from Basel III’s CVA capital charge. Banks will therefore not be required to hold capital against CVA generated by trades with non-financial counterparties – an exemption designed to apply to trades with corporate users of derivatives, but which banks believe could also cover SSAs.

If the exemption does apply to sovereign derivatives users, it would tackle the CVA feedback loop and reduce some of the charges banks would have to shoulder in relation to swaps derivatives transactions with their SSA clients. 

“Whatever way you look at it, the market is changing,” said one fixed income banker. “The dialogue is real and it is happening.”

Dealers hope that increased credit charges will ultimately make it prohibitively expensive for those sovereigns with elevated credit spreads to trade swaps unsecured. But they see the perils of holding a gun to their clients’ heads by refusing to trade with them. Finding a way of stopping smaller rivals from muscling in on the market and undercutting them by as much as 10bp in some cases, is a bigger immediate concern, but a battle they believe they can win.

“We are reaching an inflection point,” said one head of debt capital markets. “Just as the age of cheap loans will come to an end and European borrowers will rely more on capital markets rather than the loss-leading practices of friendly local banks, so this landgrab in the swaps market by second and third-tier players will come unstuck.”

A source at one Spanish bank, which has been gaining market share, said: “This is not irresponsible. There is a timing arbitrage here before rules are set in stone. And as long as two-ways CSAs are not mandatory, SSAs will want to shop around.”

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