A niche corner of the interbank lending market between Western and emerging market financial institutions has been thriving behind the scenes of volatility in public EM markets, as its activity spreads across regions and innovation in its financing products flourishes, writes Ross Lancaster.
It is a market still without a precise name. Structured funding is the most catch-all description of this private lending format, which creates avenues for dollar funding to emerging market banks — but also sometimes euros. It does so by means of repo and derivatives-style transactions that can rival the public bond markets in transaction size.
This structured funding market has existed for nearly a decade. But it is evolving well beyond its origin of simple repo transactions that gave EM banks access to dollars by way of collateralising mainly local bond holdings. Global investment banks active in the business are now accepting an increasing variety of collateral for their EM dollar lending, including structured notes, covered bonds and murabaha.
These banks are also harnessing the technology of derivatives markets to innovate financing to regions as far spread as Africa, China and Latin America. While these business lines are creating new options of dollar lines for the EM borrowers they are also proving to be a capital-efficient lending tool for their international providers.
Total return swaps (TRS) in particular have proven an efficient and popular method of funding. Some banks have even been able to use the product to intermediate Western institutional investors’ funding of EM borrowers, as the shoots of a market for non-bank lending emerge.
“More and more we are seeing TRS or structured repo-based structures being employed,” says Jonathan Haines, a partner at Ashurst in London, “where the funder acquires an asset from the borrower and then pays back the return on that so the borrower retains exposure to the asset and makes an interest type payment on the cash leg of the transaction.”
For the borrowing EM banks, the market provides access to dollar funding that can be unlocked with the use of local collateral. For the international banks, it provides a much more capital-efficient form of lending than unsecured dollar funding would.
“If you want to lend to EM banks unsecured you normally have to set a lot of capital aside for RWA (given ratings) and for balance sheet utilisation,” says Nitin Sawhney, managing director, international trading solutions and head of EMEA structuring at Credit Suisse in London.
“However, when structuring the financing transaction in a repo or derivatives framework, as long as you have a sufficient level of haircut (and subject to the lack of correlation/ legal connectedness) then these transactions can generate only small amounts of risk-weighted assets for repos (and for derivatives — small amounts of RWA and low balance sheet utilisation too). It will not be anywhere near the RWA of an unsecured loan.
“That is the attraction for the lenders, one gets paid less but the risk and capital usage is less allowing larger financing nationals.”
The geographical range of structured funding is spreading throughout the globe. The Middle East, North Africa and Sub-Saharan Africa provided an increasing amount of dealflow for banks in 2018, according to market participants who spoke to GlobalCapital. Egypt, Ghana and Nigeria were all mentioned as big markets. There has even been some activity sourced in Greece.
The Middle East in particular was marked out as a growth area though. There, murabaha has become an increasingly accepted form of collateral in structured lending transactions.
The market has also been expanding to include central bank and EM sovereign borrowers. In November last year, the central bank of Egypt rolled over a $3.8bn repo agreement — initiated as a $2bn transaction using dollar-denominated sovereign bonds as collateral in 2016 — with a consortium of nine mainly international bank lenders.
In August, the government of Ecuador also adopted the funding method as it entered into a $500m repo with Goldman Sachs. For the first time in a repo, the sovereign used state bonds as collateral instead of gold.
There is also a nascent market for intermediation growing from the inter-bank EM structured funding format.
Some institutional investors have been willing to take on the lending role in the repo arrangement by borrowing the EM bank’s asset and paying out dollars for it.
To take one example, that investor can then enter into a TRS with an intermediating Western bank that collects the asset’s cashflows and pays a funding rate for the dollars. The bank then enters into back-to-back TRS with the EM borrower, this time paying out the asset’s distributions and receiving the dollar funding rate.
The arrangement gives the investor recourse to the intermediating bank if the EM borrower defaults on the loaned asset. It also gives the firm recourse to the asset if the intermediating bank goes under. The intermediator charges a spread on the funding rate received from the EM bank and the one it pays to the investor.
“We can take more exposure off balance sheet by using third party funding, where we use European insurers or banks or other investors to fund the purchase of the EM borrower’s assets and take the risk on to their balance sheet,” says Sawhney. “We then sell them protection on those assets through a variety of derivatives, such as the TRS. So we still run the correlation risk between EM collateral and EM counterparty but with close to no RWA impact at the right level of haircut.
“Furthermore, typically a TRS transaction like that would use only 20% leverage as opposed to an on balance sheet financing transaction which would use 100%. That means about five times less capital usage when these trades are taken off balance sheet.”
This is but one example of the way in which this EM funding activity can be structured. Others include making dollar payments contingent on ISDA-style credit event definitions.
There is also a widening pool of collateral, with covered and corporate bonds being used, and considered, for transactions. EM banks have also begun to package illiquid loan portfolios into structured notes that can then be used as collateral in the repo transaction.
“Some of these transactions involve not only bonds (whether government bonds or structured finance or repack notes) transferred into the TRS but also less liquid assets, often involving sovereign risk,” says James Knight, a partner at Ashurst. “That can add substantial extra complexity.”
Trouble at home: Turkish crisis survived
One of the most fertile grounds for innovation has been Turkey, whose banks were recognised as especially sophisticated counterparties by market participants speaking to GlobalCapital. It is recognised as one of the most mature markets for EM structured funding and indeed one of the original sources of activity for the business.
It also had to contend with a full-blown EM currency crisis in 2018.
As the Turkish lira plummeted and the yield on the sovereign’s 10 year bonds surged to above 20%, the country looked set to claim pariah status among emerging market investors. The whipsawing FX volatility caused paralysis in the inter-bank market between Turkish and international banks, according to one interdealer broker at a leading house in London during most volatile depths of the crisis. Interbank FX trading had seized up with firms only managing existing trading positons, he added.
But in the structured inter-bank market, activity was holding up robustly.
“When Turkey’s local currency and bond markets were selling off its banks faced some very large margin calls from across all the international banks,” says Sawhney.
“There were no issues in meeting those calls that I am aware of, all the banks had ample liquidity and were able to meet their margin calls quite easily. A lot of the banks were in fact very quick to post collateral even when they didn’t always agree with the valuations.
“That was apparently a message that came from the regulators. Typically in times of volatility assets are often all over the place. You can easily end up with different valuations for the same asset. Bid-offers can move very wide intraday. But we had barely any disputes, around 95% of margin calls were absolutely met undisputed which was remarkable.”
Another market participant told GlobalCapital that Turkish dealflow is back in swing after some reviewing of collateral triggers during the summer. He added that by the autumn the market was “not materially constrained”.
Of course, while the Turkish situation proved an encouraging test for structured funding in that region, it is hard to draw hard lessons for activity in other jurisdictions. What worked in a highly sophisticated market may well not translate to a more frontier market, however well collateralised the deal may be.
Bankers seeking new business lines will have to sharpen their pencils on the peculiarities of each local market that they push into. “Risk assessment has to be done on a case-by-case basis,” says Antoine Broquereau, global head of financial engineering, fixed income, at Société Générale in London. “In EM the governance can be very difficult from one country to another. We obviously can’t say that because Turkey was well managed the others can be.”
Broquereau points to China as one example of a jurisdiction where even a structured financing executed by straightforward repo can be complicated by the local market.
“In China there is an element of difficulty in the market, you can access the local bonds but can only liquidate them in the Chinese market. That is an important feature of the local market that can prevent more development.
“It shows there are specificities in each and every market and that each transaction is quite unique. As a lender you need to make sure that you are covering tail risk.”