"It is without question the biggest operational issue the market faces," says Sean Taor, global head of syndicate and debt capital markets at RBC Capital Markets about the cost of funding derivatives positions with supranational and agency counterparties. "The questions around this are very emotive."
The industry has re-evaluated the value of risk, funding and liquidity like never before since markets began to seize up in 2007. The result is that banks can no longer ignore the cost of funding swap positions on their books with SSA borrowers.
"The costs are often way in excess of the fees that the banks earn on the related bond deal," says one head of debt capital markets in London.
The exorbitant costs that abound could jeopardise the long-term stability of the SSA market unless issuers move with the banks and start signing two-way credit support annexes with their swap counterparties.
"The whole model has to be sustainable," says Taor. "The business cannot survive as a loss-making entity because resources will be placed elsewhere and the market will become less robust."
The key to the solving the problem and minimising funding costs is for issuers to start posting collateral either through bilateral two-way credit support annexes with swap counterparties or membership of a central clearing party which would require the same sort of agreement.
"It is in the interests of the whole industry to introduce two-way CSAs," says Elie el Hayek, HSBCs global head of rates. "It will reduce the cost for everybody banks and issuers. Everybody will profit be they a big or a small bank because everybody has to charge for the funding it isnt free."
Traditionally, where CSAs have existed between an SSA borrower and a bank, they have tended to be one-way agreements. Under such an agreement, when the present value of a swap trade between the two swings in the borrowers favour, the bank must post collateral to them. However, when the trade is in the banks favour, no collateral is forthcoming to the bank.
The reasoning was, as a triple-A counterparty as virtually all SSAs were and many still are why should the better-rated, virtually risk-free institution have to pay for credit with a worse-rated bank?
Before 2007, banks were happy to swallow or ignore those costs. Pricing a swap aggressively to help an issuer meet its best possible cost of funding was and continues to be one of the main components in winning a new issue mandate. It became part of the service that issuers expected to receive in return for the fees they paid on the bond deal. Much of the swap business involved hedging vanilla interest rate risk by swapping it into floating rates in euros or dollars. There was nowhere to hide such a charge in such a competitive and seemingly straightforward market without risking missing a trade, souring a relationship and losing places in the league tables.
Today, however, banks face much stricter controls on their credit and swap lines. Regulators and internal risk managers demand that the bank reserves cash when it is not receiving it or collateral from a counterparty.
Bankers insist it is a charge for funding and not an assessment of the borrowers risk profile.
"One-way CSAs are not so painful from a credit perspective but from a funding perspective," says Allegra Berman, UBSs global vice-chairman of global capital markets. "The cost of funding is generally a much bigger problem than any credit charges."
UBS and Credit Suisse provide two examples of how much more integrated the consideration of the risks associated with new issue swap trading have become.
"UBS has an integrated business where primary and secondary bonds and derivatives costs and revenues are all in one pool," says Berman. "We pay a charge if a swap position with a client is in the money and we arent receiving collateral, even if it is not related to a new issue and so we are acutely aware of all the costs of the business. UBS is uniquely set up like that in SSAs.
"If more banks had this more holistic approach to the business theyd have a more comprehensive understanding of the issues. And as a risk management business, it is a much better model to follow because you can be completely transparent with your clients."
"We look at evaluating charges on a portfolio basis so there is a lot more thought that goes into each individual pricing for a transaction," says Greg Arkus, head of public sector debt capital markets at Credit Suisse in London.
The problem is not limited to the public benchmark business. In the MTN markets one of the few structured products regularly issued is one of the most volatile. Since 2009, the sale of callable zero coupon bonds to Taiwanese life insurers has rocketed.
These bonds are almost all 30 years long, and contain Bermudan call options making them quite risky products when it comes to the new issue swap to hedge them. That means they take up a lot of swap line. Moreover, many are swapped back into Euribor funding which creates a further funding discrepancy and so higher charges.
Yet these charges have not stymied the flow of business. Whereas bankers at bigger firms complained last year about fierce competition for the deals taking up too many resources for too little return, now some of those banks have withdrawn from providing those swaps altogether.
Instead, the risk is being placed with banks much less well equipped to run it, say bankers.
"The callable zero coupon business is not being killed by funding charges because there are third and fourth tier banks from non-core Europe who dont have any experience or up-to-date risk management models, " says one head of SSA origination. "They have no concept of funding. They are being tapped by some of the more experienced issuers who have no outstanding lines with these banks and so source a swap in the secondary market. The arranger may be a top tier house but the swap counterpart is a third or fourth tier bank."
Such banks are also starting to win the bond portion of the trade themselves too. "Some of the houses winning the zero coupon callable deals into Asia are doing so because they arent properly pricing in all charges," says Arkus.
That could have worrying consequences for the industry. Banks, from what one banker describes as "Europes hinterland", are holding risk and aggressively competing for more while offering no reassurance that they know the value or downside of that risk one of the core problems with the banking system that caused the systemic problems markets and governments are still reeling from today.
There are signs, however, that not all issuers will tolerate such cavalier practice in order to wave cash through the door. "This is a systemic worry," says the head of SSA origination. "One issuer started doing this about nine months ago but then put the brakes on six months later because they were worried about counterparty risk. They wanted to restrict their swap lines to the more experienced banks in the market. That brought them extra costs but they are trying to find a way around that."
Now that the charges mainly applied by bigger banks are starting to hit issuers in the pocket, they are finally facing up to the problem, bankers say.
"Only one agency has helped the situation by posting its own bonds as collateral in a two-way CSA but they stand alone," admits Berman.
However, many other SSA credits are holding out. The reasons are familiar, say bankers. They say they do not have the operational ability to run a collateral management operation. This would require putting new systems in place and hiring new staff. But bankers argue the long-term savings on offer over a number of trades would save money.
"It may be painful to set up a collateral management operation but we are talking about clients who raise north of $10bn a year and a high percentage of that is swapped," says Giles Hutson, head of Bank of America Merrill Lynchs EMEA DCM team. "If they can save a few basis points on each trade by posting collateral, that is a material amount of money."
"It is not such an onerous effort to find collateral," says el Hayek. "The bigger issuers are well set up and staffed to post collateral. The smaller issuers need to ugrade a little but it will pay for itself in terms of lower costs on derivatives."
A second complaint is that borrowers have a hard time justifying increasing their borrowing requirements just to provide cash to, well, borrow more cash with. "One potential problem is for borrowers that are confined in terms of balance sheet size and who have to maintain certain leverage ratios," says Arkus. "Depending on the netting position, they may need to increase their balance sheet substantially to post required levels of collateral."
But that should not prove such a problem for some supranationals and agencies, says Bill Northfield, head of SSA origination at Deutsche Bank.
"There is a debate brewing on whether some clients would need to fund more to raise collateral," he says. "Several clients already hold liquid positions in the securities you would post as collateral. Equally, they are already warehousing liquidity as they receive securities collateral securities that can be repod for cash and then that cash posted elsewhere. Also, in some jurisdictions you can post your own bonds as collateral."
Banks are applying pressure across the borrower spectrum to push two-way CSAs in a bid to drive down swap costs.
"Every bank is having bilateral discussions with every issuer," says Taor. "And the discussions are continuing."
It is a welcome discussion from the banks point of view and one that, they say, is of mutual benefit to dealers and issuers or at least can save borrowers from further pain in the long term. With the increased costs of funding starting to hit borrowers, they appear to be more willing to consider two-way CSAs.
"The idea that these issuers are escaping these charges because they always have is changing," says Berman. "For this group of borrowers and given their mission, they should acknowledge this and help the banks because this is only going to create a problem further down the line when banks start passing these costs on."
Some two-way CSAs exist between banks and public sector borrowers but then some of those have uneven thresholds at which each counterparty has to start posting collateral meaning they effectively still operate like one-way CSAs. However, these contracts will have to change too if the funding costs are to be overcome. Unsurprisingly, some borrowers are reluctant to shift.
"Some clients have been quite helpful in lowering their thresholds but there is a long way to go," says Berman. "Some of the very big supranationals have done nothing and this is not good for the long-term health of the markets."
"Some borrowers have put in place two-way CSAs with ratings thresholds," says Arkus. "They might not have to post collateral while they are triple-A but they will if they get downgraded. That helps with the credit charge but to help the funding charge entering a two-way CSA posting collateral from the start is optimal."
"More banks on the Street are becoming aware of the implications of one-way CSAs and funding costs," says Northfield, as their valuation models become more sophisticated. It makes pricing for SSA clients with asymmetric CSAs more challenging. In the next 12-18 months, well likely see a move towards more two-way CSAs, either direct or driven by central clearing considerations."
But, as should be expected for a market that operates exclusively on bilateral contracts and over-the-counter products, the reform landscape is uneven.
"Some issuers are willing and able to sign two-way CSAs, others are less willing," says Taor. "Some dont see the need as they havent seen a drop in competitiveness from banks. Others are unable. They cannot manage collateral."
As with the MTN business, there are always banks willing to undercut the opposition to win market share and that is of no help to the reforming of the industry to a more healthy standard, say some bankers.
"Most issuers understand the status quo is not good for the industry but still some banks are unwilling to pass on all of the costs," says Taor.
One thing that would help drive the reform would be a more co-ordinated drive from the public sector. Regulatory proposals target a greater appreciation of risk than had hitherto prevailed.
"The direction the regulatory landscape and Basel III is headed in suggests the endgame may be a collateralised world," says Hakan Wohlin who runs global debt origination at Deutsche Bank.
Yet bankers express frustration that the borrowers that in their eyes emanate from the same world as the regulators the public sector do not seem to be quite so keen to fight the good fight.
"The current situation is unsustainable long-term and is a consequence of borrowers unwillingness to enter into two-way CSAs," says one senior SSA banker. "Sovereigns for example want less systemic risk but dont always lead by example."
El Hayek thinks that on the whole, the supranational and agency sector has been, by dint of its advanced use of swap markets compared to the sovereign sector, more willing to consider new agreements.
"Supranationals and agencies are a little more advanced in their use than sovereigns," he says.
"They have been more willing to explore changes in CSA agreements. They also dont have the same constraints in terms of derivatives accounting and Eurostat treatment that the sovereigns face."
Depending on interpretation, Eurostat counts cash posted as collateral to a sovereign as a loan which therefore increases its debt to GDP ratio.
The use of central clearing parties for swaps has been mooted for some time by regulators on both sides of the Atlantic. The consequences for supranationals and agencies could be profound but detail is scarce and what little there is seems at conflict with the use of the products.
"The level of detail on proposed reforms is not enough," says Berman. "Multinational bodies will be exempt from clearing centrally but that seems very odd to me given what heavy users these institutions are of derivatives."
As banks generally welcome two-way CSAs, so they welcome central clearing. The two both require members of the clearing house to post collateral meaning that the whole system is safer.
Yet there may be further hazards to SSA issuance here too. Although light on detail, the reforms have suggested that structured products will not be permitted through exchanges or central clearing. That would hurt some of the smaller agencies who rely on structured bonds for much of their funding.Although Municipality Finance told EuroWeek in December it was mindful of the potential hazard to its own programme which has been funded in majority through MTNs, not all borrowers are paying as much attention to something that could change the way they do business.When EuroWeek asked UBSs Berman if the thought of not being able to issue structured notes in the future due to regulatory reform in the derivatives market was troubling SSA borrowers, she replied: "Not as much as it should be. Not only are structured products cost-effective for issuers but they can be long-dated and losing those would be a double whammy."
However, other bankers are more relaxed about the extent of reform in the derivatives market. "It would be very difficult to put every type of product through a clearing house," says el Hayek.
"The costs would be high and it could kill the market once these costs are passed back to investors. I dont think the regulators have any interest in killing off the market."It is not in the interests of the regulators to push those with a need to hedge into running naked positions because they have made the costs of hedging too high."