Returning the favour

IFR Germany Report 2014
9 min read

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

To purchase printed copies or a PDF of this report, please email

It has the appearance of an arcane and technical documentation issue, but a mooted change in the operations of Germany’s debt office, the Bundesrepublik Deutschland Finanzagentur, could make life much easier for Europe’s big derivatives dealers struggling to cope with the rising costs of regulation.

At the heart of the issue is the fact that sovereign users of derivatives, such as central banks and debt offices, have historically never been expected to post collateral when the trade is in its counterparty’s favour, despite the fact that dealers would post collateral, through a so-called credit support annex (CSA), when the trade was in the sovereign’s favour.

In times gone by, one-way CSAs were an accepted market convention, but post-crisis capital and liquidity reforms have made uncollateralised trades with sovereigns much tougher for dealers to fund. A handful of small European debt offices have recognised the burden and started to post collateral in recent years; if the Finanzagentur is next, dealers hope it will encourage other highly rated sovereigns to follow suit.

“Germany is one of the biggest issuers and best-rated creditors in the eurozone, so this might set a benchmark for other debt offices and central banks to follow. I guess others are probably waiting to see which way Germany goes, but it would be a welcome move as one-way CSAs are becoming increasingly challenging for dealers to handle in the current regulatory environment,” said Jens Richter, director in rates sales at HSBC.

A change of practice at the Finanzagentur could still be some way off, but it would be facilitated by a proposal in Germany’s federal budget for 2014, which is still only in draft form but will be finalised in July. The proposal would allow Germany’s finance ministry to borrow up to €8bn to fund the posting of collateral against interest rate swaps, with a cap set at 10% of the total volume of new swaps executed by the debt office.

Devil in the detail

It is just a tiny part of Germany’s colossal budget that will probably pass unnoticed by most observers, but dealers are delighted by the proposal and hope it will survive any last amendments before the final vote. The Finanzagentur declined to comment on the specific proposal, but it is understood to have faced pressure from multiple banks to begin posting collateral.

A spokesman for the debt office said there would be no change to existing collateral arrangements unless the budget ws passed in its current form.

“We don’t expect any major changes with regard to our collateral agreements with our market partners,” he said. “The Federal Budget Law has allowed the government to access the swaps market, making it possible both to optimise the structure of its debt portfolio and to adhere to a transparent and efficient issuance policy that has stood the test of time.”

While the industry will be watching closely as the budget clears the final hurdles in the coming months, some participants are playing down the significance of the budget itself, pointing out that the securing of funds for collateral will allow the Finanzagentur to enter into dialogue on the issue, but there is still some way to go.

“It is likely to be some time before we see any actual change, but it’s very important that this part of the federal budget is signed off because without the permission of the German Parliament, the Finanzagentur wouldn’t even be able to begin negotiations with its counterparties to post collateral,” said HSBC’s Richter.

The head of derivatives funding at one large European bank believes it could take up to six months before any real progress is made, saying: “It’s pure guesswork at this stage and the details have not been discussed. A lot of banks approached them to propose two-way CSAs because of the charges, but they will have to consult with all of their major counterparties and seek suggestions first.”

Collateral for funding

The industry push for two-way CSAs derives largely from the increased cost dealers face when trades are either uncollateralised or partly collateralised. Under the new Basel III capital rules, a charge for the credit valuation adjustment (CVA) is designed to capitalise counterparty risk, and as such it would be higher for an uncollateralised trade.

Banks have also started to incorporate a funding valuation adjustment (FVA) to account for the funding cost they face when trading and hedging uncollateralised derivatives. JP Morgan brought FVA into the spotlight in January when it revealed a US$1.5bn loss as a result of implementing FVA for OTC derivatives and structured notes.

“Most major banks have now rolled out FVA and are charging for it on one-way CSAs, so sovereigns and supranationals that don’t post collateral are now seeing completely different pricing to what they are used to. The reason sovereigns will move to two-way CSAs is to ensure competitive and tight pricing in that changing environment,” said the head of derivatives funding.

In a joint paper assessing the impact of sovereign collateral policies, published in December 2011, three leading industry associations – ISDA, AFME and ICMA – estimated that one-way collateral arrangements with European sovereigns could drain as much as US$70bn from the financial system. One-way CSAs, the associations said, had created significant credit risk and a threat to liquidity in the financial system, so sovereigns should therefore consider posting collateral.

But despite that warning, progress within the derivatives client set typically labelled SSA – sovereign, supranational and agency – has not been as rapid as some participants would have liked. Debt offices that have made the switch to two-way CSAs include Denmark, Sweden, Portugal and Ireland. If the Finanzagentur does move, Germany would be by far the biggest issuer to post collateral on swaps.

Some believe it is only now that the higher costs of trading on a one-way CSA are being felt more acutely, that major sovereigns are beginning to consider collateral posting.

“In today’s regulatory environment, if a client is not willing or able to sign a two-way CSA, there are several charges that have to be added to the execution price, which in turn would lead to wider bid-offer spreads. The CVA charge, which is based on the creditworthiness of the counterparty, is required under Basel III for all uncollateralised swaps, while additional charges are also now made for the FVA,” said HSBC’s Richter.

“Sovereigns use derivatives to manage liabilities and funding, and posting collateral under a two-way CSA creates additional cost, so it will be for each individual country and institution to determine what makes sense,” he added.

Sluggish progress

If large sovereign issuers have been reticent in moving to two-way CSAs, central banks have been even slower. The Bank of England made the switch in 2012, noting the increased costs that had resulted from the one-way provision of collateral, but it did not create the catalyst of change that some had hoped for at the time.

“It is not as easy for issuers to post collateral as it is to receive collateral and this move does have implications for their funding and liquidity, as well as bringing a considerable documentation challenge. But the concern is that without two-way CSAs, it will be very difficult for banks to operate as they have done previously, particularly in the rates market, which is not good for issuers long term,” said a senior SSA-focused official at one Canadian bank.

The scale of the issue is brought into focus by a head trader at a rival Canadian bank, whose credit department is making it increasingly difficult to take on new clients on a one-way CSA, no matter what their size or revenue potential for the bank might be.

“Even if it’s the biggest central bank out there, it would take an incredibly strong business case to get internal approval for a one-way CSA now. From what we can make out, the pool of counterparties that would accept one-way CSAs is diminishing, but it’s quite clear that some of the sovereign institutions will hang on as long as humanly possible because they don’t want to let go of the financial advantage they have,” he said.

Novak Djokovic of Serbia and Rafael Nadal of Spain play an exhibition tennis match at a court set up on the deck of a ship