For some sovereign borrowers, the bond markets have been like a jungle path at night in 2010: hazardous, hard work and at times, impenetrable. However, of almost equal importance to many of those borrowers are the swap markets.
Uncertainty has engulfed them too this year as banks and their clients have had to react to regulatory reform and a sea change in the pricing of credit and liquidity.
For years, sovereign borrowers have been used to getting their swaps away at next to no cost. But all that could be about to change. At the heart of the problem is the increasing cost of extending lines of credit. Banks, after years of trading on prices within a whisker of so-called mid-market prices, can no longer stomach the cost of giving a collateral free pass to counterparties.
That free pass comes in the form of one-way credit support annexes: bilateral agreements between two parties governing among other things how swaps between the pair are collateralised. Traditionally, sovereigns have demanded it is only the banks that have to post collateral to them when the net present value of a swap is in its favour. When the trade was in the money for the bank, the sovereign did not have to reciprocate, arguing that, as a sovereign, it posed no risk of defaulting or becoming illiquid.
Then the credit crunch came along. To the extent that dealing costs have risen and credit standards been tightened and may well tighten further under Basel III the market has now evolved to the point where Portugal has begun work to put in place two-way CSAs with its swap counterparties so that it can keep its costs of derivatives dealing down and keep lines open.
"Sovereigns have been using derivatives for liability management and hedging of bond issues as much as in any other year," says Kentaro Kiso, head of the public sector group at Barclays Capital. "But from the banks side, the awareness of this derivatives exposure to sovereigns has moved to a different level.
"The reality is, it is an overhang cost to the bank and it is expensive with one-way CSAs where the sovereign will only accept government bonds or cash as collateral."
Market participants do not suggest this applies to all sovereign credits and nor is it purely a matter of banks getting the jitters about sovereign default, although that is not far from their minds in some cases. "Certain countries had a lot of credit problems so trading derivatives became tricky for them," says Elie el Hayek, HSBCs global head of rates. "The triple-A countries continue to use derivatives as they have in the past with no big changes, however."
Although predominately a liquidity issue at the moment, there may be further unknown charges for banks to pass on to sovereign swap counterparties to come, such is the uncertain regulatory environment. "There is also an element of credit charge sometimes and now potentially also a capital charge," says Kiso. "The Financial Services Authority is looking at derivatives books and putting a contingent charge on the exposure. It will be a double collateralisation. There are a lot of unknowns at the moment."
Banks argue that there are myriad advantages to sovereigns following Portugals lead and taking a more serious look into two-way CSAs. The ability to cancel out in and out of the money trades will relieve the burden on banks to find cash or government bonds often the only securities sovereigns will accept to post as collateral. Whereas the charge was once absorbed by the bank, it has grown too large for such generosity but a two-way CSA would allow banks to lower the charge once more.
With sovereign and bank financing so intertwined, both parties could benefit from such a move. It is becoming the case that only the biggest balance sheets can consider one-way CSAs. That limits the number of counterparties available in the market and therefore, concentrates risk.
"If you have a smaller list of counterparties, you run greater credit risk," says Christina Cho, a derivatives marketer at BNP Paribas covering SSA credits. "So you have to find ways to diversify your list of counterparties. You have to be very careful with what you do with credit lines nowadays."
The move could also lead to lower borrowing costs for some sovereigns, argues el Hayek. "Some of the banks hedge the swaps they do with sovereigns by buying CDS on those governments." he says. "This pushes the CDS level up which may impact the level they can issue at so it is in their own interests to have the best pricing when they need to hedge something. It is in the interests of all countries who use derivatives to have two-way CSAs."
Many supranational and agency issuers benefitted from one-way CSAs too although as the various crises have swept over markets since summer 2007, some have been forced to sign two-way agreements with banks to free enough swap lines to do the volume of business necessary.
One of the traditional arguments that such borrowers used before against signing such agreements was that it would incur too much operational cost to post collateral. It is an argument that many sovereigns rely upon today: that unlike banks, they do not command huge back offices staffed purely for the purpose of administering the trades.
However, for countries with one-way CSAs in place, the marginal effort in posting collateral in addition to receiving it should be straightforward and not prohibitive, say bankers.
"It depends on each sovereign individually but I dont see it as a major problem and I imagine they would want to handle it in-house," says Cho. "It is only a case of hiring people and setting up systems. If they already have one-way CSAs, it is only a case of handling the reverse. They just have to figure out who in the department can receive cash and who cant and so on. It is definitely not rocket science."
Bill Northfield, head of sovereign, supranational and agency originations at Deutsche Bank, says the issue of two-way CSAs should be approached on an individual basis. "For the supranationals and sovereigns, it will be a focus as banks prepare for the implementation of Basel III," he says. "Equally, while some triple-A issuers might not think its worthwhile to upgrade to a two-way CSA, we have been contacted by clients who are seeking to expand their exposure to us and so they have initiated two-way CSA discussions as a means to open up greater trading capacity. That said, posting collateral is not right for everyone. For issuers who already have the ability to value OTC portfolios and receive collateral, they should certainly be able to accept collateral."
Indeed, bankers feel that not every sovereign needs to sign a two-way CSA with its swap providers despite the obvious temptations. "From the banks perspective, its probably quite obvious and trivial to say two-way CSAs would make us more aggressive in terms of pricing," says Myles Clarke, head of the frequent borrower syndicate at the Royal Bank of Scotland. "But Im sure borrowers have examples where that aggressiveness has not been weakened this year. Theyve still been able to do their business at their preferred levels."
Whats in the post?
There is also hope in some quarters that sovereign borrowers will start to accept different forms of collateral. If they start to receive and post less expensively sourced securities, it will be another way to keep a lid on costs. Though restricted to government bonds or cash in the majority of cases at the moment, one bank expressed its desire to use gold or carbon emission rights. While bankers report some issuers are listening to these ideas, the pace of procedural change in sovereign debt markets remains as glacial as ever.
"We would love to post these things but collateral management teams are very rigid and selective about what they want to receive," says one SSA syndicate and origination manager. "Negotiations are ongoing but slow."
Other banks are less concerned about innovating new forms of collateral. "As long as the bonds are posted with the appropriate haircuts then we do not mind if the collateral posted is cash or bonds," says one SSA debt capital markets officer. "After all, we do not approach this on a credit basis but on a liquidity basis.
"There is a tiering of haircuts depending on the maturity of the bonds posted and as long as the haircuts are appropriate and the bonds are eligible for repo I dont see a problem. Every house will have a different view. It will still have a small impact on the credit charge as the counterparty will have a liquid security as collateral that it didnt have before.
"The problem arises in a default scenario where it is very difficult to assess your recovery rate on the collateral that you hold but default scenarios are a God forbid scenario."
For what will count as collateral in one or two-way CSAs or whether sovereigns will sign them at all may hinge on the change in the balance of power that this liquidity problem has brought to markets.
"We could expect more sovereigns to take up two-way CSAs because they dont have the same status that they used to have as infallible triple-A borrowers," says Cho. "That has given banks more of a leg to stand on now in terms of the arguments they can use to propose two-way CSAs."
Wherever the negotiations lead to, Cho is not convinced that genuine two-way CSAs between sovereigns and banks will become the new standard. "When we say bilateral CSAs with sovereigns, are they really going to be bilateral?" asks Cho. "Well, probably not."
Instead, sovereigns could opt to make things cheaper for themselves by raising the point at which they need to receive collateral from a bank making it less likely the bank will have to incur such costs in the first place.
The next step on from two-way CSAs is also at the heart of the regulatory reform debate in derivatives markets on both sides of the Atlantic: clearing houses or central counterparties. In Europe, sovereigns will be exempt from having to join clearing houses as proposals stand. Daily margin maintenance with the exchange would be an even more onerous operation than running a two-way CSA. "You have your initial amount upfront and also an independent amount that you post in addition depending on your rating," says Kiso. "Then there are frequent marks to market and that is a lot of operational cost for a sovereign."
Yet if sovereigns were to join derivatives exchanges, this would provide a great deal of market stability and also help to ease the burden on the state of supporting a banking sector, say bankers. "A lot of sovereigns and even supras and agencies realise that going into a central clearing party is a laborious process," says Kiso. "Two-way CSAs can be less labourious and more cost-efficient but these sovereigns really need to foster a liquid interbank market by supporting CCPs [central counterparties]. Somebody at the sovereign level has to push these processes. In the US it is the government and regulators that push this process, not banks. In Europe, it is the banks pushing it. They need the whole system to be more robust and transparent. You need the authorities help to do that. They need to sponsor it. A system driven only by banks will be weak."Again, the pace of change in the sovereign swap market is not likely to be rapid. For issuers that almost never put on a vanilla interest rate or cross-currency swap that hedges either a new issue or alters the duration of their portfolios, it is unlikely they will look to embrace the complexities of joining a clearing house despite the possible benefits. "You need to justify the effort with a big turnover," says el Hayek. "Bilateral CSAs are a first step and as the clearing market develops sovereigns can use banks to do the clearing for them. There would still be a little credit risk but not as much as if the bank only faced the clearing house in the swap. The swap would be back-to-backed through the bank to the clearing house so the bank is hedged and doesnt have to charge as much for the credit exposure."
Basis for issuance
Italy a familiar name in this market place placed $2bn of three year bonds in September. As recently as the end of November, Nomura managed to find ¥20bn of 20 year demand for Spain at a time when the country was on the verge of being sucked into the eye of the sovereign crisis.
"It is starting to make sense for investment managers to consider yen as a currency," says Elie el Hayek, HSBCs global head of rates. "It is still a little bit shy but has been driven by lower yields elsewhere. The yields between yen and other currencies are now similar and since the yen has appreciated a lot, people start to see it as a currency to invest in which has made yen an attractive issuance currency for some borrowers."
European banks needing to fund dollar assets, in combination with international investors exiting euro holdings, have driven the market levels in the euro/dollar basis swap with basis swap markets generally quoted against three month dollar Libor, it is the market through which all euro borrowers must pass before swapping into other currencies.
With concerns about the eurozone far from over, the market may well remain favourable to European sovereigns looking to raise foreign currency bonds for some time to come. The fact the arbitrage opportunity remains despite the issuance of dollar bonds by so many European borrowers demonstrates the markets depth. By nature of the currencies involved it is also a relatively liquid market.
Not all basis swap markets are created equal, however. "Aussie dollars back into euros is quite difficult," says Kentaro Kiso, head of the public sector group at Barclays Capital. "There are a lot of funding charges because the FX and FX forward volatility and the interest rate differentials are quite large so we would want to face counterparties with two-way CSAs."
Whatever arbitrage opportunities basis swaps provide in the year to come and however the new collateral and capital requirements for banks manifest themselves, sovereigns can no longer have the swap market all their own way. "It is a case of finding where the flexibility is in the system for the entire market to have better funding flexibility overall," says Christina Cho, a derivatives marketer at BNP Paribas covering SSA credits."Sovereigns do not want to increase systemic risk in the financial sector. They do not want to extend funding risk so it is a case of finding a way of achieving that without increasing the cost of funding to and the operational burden on the sovereigns."