UPFRONT: Show us your swaps, Mario

IFR 1919 4 February to 10 February 2012
9 min read

The Italian Treasury has a colossal derivatives portfolio. At as much as €30bn outstanding by most estimates, bankers agree that Italy is the largest sovereign user of derivatives. There is nothing inherently wrong with this; treasuries are well within their rights to use derivatives to manage their interest rate risk.

But there is an issue with Italy refusing to shed light on exactly how much money it owes under its derivatives contracts, and whether it is in danger of having to pay up on these trades in the near future.

This lack of transparency is particularly troubling for a country whose national debt is the subject of intense scrutiny.

Take the latest news gleaned from Morgan Stanley’s financial results. It matters how exactly the US bank managed to reduce its swaps exposure to Italy by US$3.4bn. If an interest rate swap was restructured or assigned to another bank, Italy may not have had to pay up on the swap. But if the swap was unwound – as some believe it was – Italy would have had to cough up a cool €2bn.

This hardly constitutes small beer, particularly when we’re talking about a country that has struggled to get debt auctions out the door in recent history.

The EBA stress tests showed that Italy owed eurozone banks €5.1bn on swaps, and that’s not including the swap-heavy US, Swiss and UK banks. Dealers are losing patience with holding these positions (which are increasingly costly in the new regulatory regime) and will do anything they can to unwind them.

The bottom line is that Italy would have to pay up many billions of euros if forced to unwind these trades. Investors – not to mention the Italian people – have a right to know how large this contingent liability is, and if there is any danger of it materialising.

A growing dilemma

Facebook was never really meant to be a company, 27-year-old co-founder Mark Zuckerberg says, let alone Wall Street’s current obsession.

But, somewhat begrudgingly, the social networking powerhouse last week took the first step towards becoming a fully fledged public company perhaps worth US$100bn, less than eight years after it was conceived in a Harvard dorm room.

In filing its registration statement ahead of a possible IPO, it is readily apparent that Facebook was one of the most heavily-contested mandates in memory.

Morgan Stanley, JP Morgan and Goldman Sachs took top billing by agreeing to underwrite a US$5bn offering for a reputed 1% fee, paltry even by the standards of large tech deals.

It could be a classic case of under-promising and over-delivering given that the deal is expected to grow towards US$10bn closer to pricing in maybe three to four months’ time.

The perception is that Facebook shares will sell themselves, and the unprecedented hype around the deal suggests as much. But investor favour cannot be taken for granted.

The principal challenge lies not just in pitching Facebook’s extraordinary growth story, but convincing big investors that that growth is not already embedded in the healthy price tag.

As much as anything, Facebook’s deal is further evidence that an IPO is no longer about getting access at the ground floor, nor necessarily about raising capital.

Part of the reason is the recent revolution in the process whereby investors of all stripes are willing and able to invest prior to the IPO.

For example, T Rowe Price, historically a large buyer of new issues, is listed in the IPO prospectus as already a substantial shareholder – and the full list of institutional holders is much larger.

The fact that large blocks of Facebook shares (US$300m–$500m and above) are changing hands privately ahead of the IPO also poses unique challenges to the traditional process of price discovery.

The dilemma for underwriters, as evidenced by the initially disappointing performance of Zynga’s shares, is that existing institutional investors and others are just as likely to sell as buy in the aftermarket. Hopefully, some lessons have been learnt, because any missteps by the underwriting team will surely be long remembered.

Right pricing needs no hedge

There is no doubt that when banks underwrote the €7.5bn rights issue by UniCredit in November 2011 some felt they were in effect throwing a sharp knife up in the air and hoping not to need stitches after they caught it.

At the time, Italian bonds were yielding 7.5% and the banks had little clue of how the eurozone crisis would develop over the three-month risk period.

Yet news that at least three underwriters had put on hedges to limit their potential downside was a surprise.

For a start, the hedges – which were typically just deep out-of-the-money puts on European indices in order not to breach underwriting agreements – were unlikely to work. Stock subject to a rights issue trades on the basis of sentiment on that trade and is therefore uncorrelated with any other stock.

It seems the moves were driven by commitment committees nervous about risk in current markets that failed to appreciate the tools at ECM bankers’ disposal.

If the fees, discount to TERP and – if possible – sub-underwriting are all done right, then all underwriters should be happy with the risk/reward.

Shanghai’s grand plan

If China’s efforts to turn Shanghai into its global financial centre go according to plan, Hong Kong will be all but empty by 2015.

China’s top economic planners have endorsed a roadmap that will make Shanghai the centre for renminbi trading, clearing and pricing within the next three years. There will be a single rate for onshore and offshore currency trading, and Shibor – the city’s own version of Libor – will be the single benchmark for renminbi funding.

All of that leaves little room for Hong Kong, which has blossomed as China’s foreign exchange centre since regulators allowed the renminbi to trade outside the mainland. Once China opens its capital account, Hong Kong’s primary function as a gateway to the mainland will be redundant.

Shanghai’s grand ambitions, however, are no reason for the good people of Hong Kong to panic. Nor are they new – China’s State Council has already committed to a slightly more modest goal of making Shanghai an international finance hub by 2020.

And if Shanghai’s plans to introduce international listings are any guide, then a target of 2015 may be wildly optimistic. For all the hype and foreign interest, the international bourse has been on the drawing board for years, and there is little sign that regulators will grant it a green light while domestic listings are themselves in urgent need of reform.

Shibor has been around for five years, but remains an underused benchmark. Loans are priced against the central bank’s deposit rate, and the lack of a liquid interest rate swap market means the floating-rate benchmark is all but irrelevant for fixed-rate investors.

Changing that will require the unification of China’s many credit markets – together with their many regulatory bodies – as well as a rapid deepening of the country’s derivatives market. There is little reason to believe that either one is on the cards.

Even if China does somehow get its act together in the next 35 months, Hong Kong is not about to disappear. The city’s favourable tax rates and Western legal system will be enough to deter many international institutions from abandoning a city that has reinvented itself as a trading hub countless times over the past 100 years.

Talk of a “through train” allowing mainland Chinese to invest freely in Hong Kong stocks powered the Hang Seng to a record in 2007, and Hong Kong’s authorities speak confidently of a dual system, hinting that the renminbi will continue to trade in the city even after China’s currency becomes fully convertible – in much the same way as the Eurodollar market developed in London from the 1960s.

Shanghai’s international standing is an important part of China’s global development, but it has a long way to go before it can stake a claim to Hong Kong’s crown as a truly global financial centre.

Mario Monti/Reuters