The $29bn problem with one-way CSAs | FT Alphaville

The $29bn problem with one-way CSAs

That’s $29bn for just five banks with derivatives deals covered by one-way credit support annexes (CSAs).

For the entire financial system it might be closer to a whopping $150bn, according to Risk’s clever Duncan Wood.

What is the derivatives-deuce are we talking about? Here’s the story. Back in July, Wood broke the news that Portugal’s debt office was considering posting collateral to derivatives dealers. This was something of a big deal, since traditionally sovereigns, supranationals and agencies (SSAs) have been excused, so to speak, from this requirement. Derivatives dealers have to post collateral depending on market swings. SSAs do not.

Now, Portugal’s decision was cast largely in the context of the rising cost of credit protection for eurozone peripherals. But it seems there might be something else going on here — one that has to do with funding and liquidity, plus that $150bn figure.

To fully understand you have to dig a little bit deeper into the mechanics of one-way CSAs.

When the mark-to-market value of a trade is in an SSA’s favour, its dealer has to post collateral. That’s not usually a problem for the dealer, because the trade will inevitably have been hedged in the interbank market under the terms of a two-way CSA. So, the dealer’s hedge counterparty posts collateral to the dealer, who then sends it to the SSA. But when the value of the trade flips round –or the mark-to-market of the original trade is in the dealer’s favour — no collateral will be posted by the SSA, but the dealer does have to post collateral on the offsetting trade.

Et voilà, a funding cost.

And this is where Wood’s latest comes in. None of the above is necessarily new, but Wood has managed to persuade five interbank dealers to disclose their funding requirement related to one-way CSAs and SSAs. It tallied $29.3bn for all five dealers. Based on that number, Risk estimates a total industry funding obligation of $150bn.

That’s worrying enough, but there’s also a bit of interest rate shock here too.

As rates rise, SSAs will see the mark-to-market value of their outstanding swaps shrink and turn negative. Meanwhile, their dealers will see their marks getting more positive. That ought to be a good thing for them, but (surprise, surprise) it also means growing funding exposure. From the February issue of Risk:

Dealers expect these numbers to climb in the months ahead. Big SSA issuers have a mix of outstanding swaps, but dealers say their net position has them paying today’s low floating rates while receiving a higher fixed rate from their swap counterparties. As such, most SSAs are currently sitting on a positive market value – the negative marks disclosed by the banks are not a reflection of the net risk for their SSA clients, only of the funding costs associated with those clients that would currently be posting collateral if using two-way CSAs. The size of that group of clients could grow rapidly as rates rise.

The solution to this funding risk, according to dealers cited by Risk, is for sovereigns to give up their one-way CSAs — à la Portugal — and start posting collateral. Well, that’s not surprising, we hear you say. And indeed there is an element of turkeys voting to end Christmas here, but you have to admit there’s also a dose of hypocrisy here too. Regulators around the world are urging derivatives to be centrally cleared, with mandatory collateral posting.

So far sovereigns are exempt under European proposals.

Related links:
Lisbon move points to end of risk-free sovereigns – Gillian Tett, FT
Financial stability is getting difficulty – FT Alphaville