Warning: This is not your standard PIIGS Club Med European peripheral CDS post.
Risk’s excellent Duncan Wood reports on Tuesday that Portugal’s debt office is now agreeing to post collateral to derivatives dealers. That’s the industry standard one-way CSA turned on its head.
As Risk puts it:
The Portuguese debt office is set to become one of the first big sovereign derivatives users to bow to dealer pressure and agree two-way collateral postings. The change means the Instituto de Gestão da Tesouraria e do Crédito Público (IGCP) will begin posting assets to its counterparties when the value of a trade swings against it to mitigate the risk that the debt office might default.
So, enter the sovereign two-way sovereign CSA.
For, as Risk notes, the one-way CSA generates a couple of problems for dealers.
For a start, if the sovereign isn’t posting collateral when a trade moves in a dealer’s favour, then the dealer has to hold enough capital to cover their unprotected position. Burdensome, to say the least.
What’s more, the dealer would normally hedge client trades like these by taking the opposite position with another dealer. So for instance, if the trade moves in the sovereign’s favour the dealer would post collateral to the sovereign but it would also receive collateral from its hedge position counterparty. However, if the client trade shifts to the dealer’s favour then the dealer isn’t receiving collateral from the sovereign, but is still paying collateral to its hedge counterparty.
Sovereigns posting collateral then, is one way to ease the capital, collateral and cost constraints on derivatives dealers. The big question really is why would Portugal want to do this?
A couple of thoughts.
Without placing too much emphasis on the peipheral angle, let’s just note that Portugal is one of the weaker sovereign credits out there. It may simply be that it cracked first. Risk certainly seems to suggest that a number of sovereigns may be interested in following suit.
But eagle-eyed readers may also remember a certain CDS/CVA assertion in the IMF’s last Global Financial Stability report, and echoed by the Bank of England in June.
Because sovereigns usually don’t post collateral to dealers, dealer banks have to go out and hedge the trades through their Counterparty Valuation Adjustment (CVA) desks, often by purchasing sovereign CDS. The IMF and the BoE both thought this dynamic might be one of the things causing sovereign CDS spreads to widen in recent years.
Sovereigns posting collateral could effectively negate some of the need for hedging through CDS.
Which means Portugal may have just made a bid to contain its sovereign CDS spread.
One last question; what the heck will sovereigns post as collateral?
We’re guessing local bonds won’t be suitable, which probably leaves just cash.
As Risk puts it (rather mildly) :
Switching to a two-way version of the CSA – which sets out the terms for collateralisation – means sovereigns face a potential drain on liquidity. It also comes with accounting and operational challenges.
Related links:
Of CVA and sovereign CDS – FT Alphaville
Making a market in sovereign CDS - Deus Ex Macchiato
Sovereign CDS: “You can’t blame the mirror for your ugly face” – Citi, via Scribd