Banks are looking at new ways to finance their short-term exposures in the face of tough capital rules, with sovereign bonds being increasingly used as a replacement.
The series of ratios and balances set out under Basel III and the new market risk framework have made it more expensive for businesses involving derivatives and leverage.
“Regulation has made hedging more expensive for the client, either directly by the price or indirectly via availability or liquidity effects,” said Guido Herbert, global head of fixed income structuring, HSBC.
The repo market, which is used by banks as a crucial source of overnight funding, is being increasingly affected by the capital rules. For repo, where assets are borrowed against cash, and then back-to-back the bank borrows cash and lends assets, will consume leverage under Basel III.
As a result, this drives up the cost of collateral and potentially impeding the use of certain derivatives markets for long-only investors.
However, some banks are employing alternative ways of trading. Some sell-side traders have replaced the cash leg by using another high quality asset, such as US Treasuries, in order to exchange assets with other less-balance sheet intensive assets that do not consume leverage.
“This means treasuries are becoming monetised, being used to assess the value of other assets instead of cash,” said Arie Boleslawski, deputy head of trading, Societe Generale.
Banks are also adopting total return swaps (TRS) as another alternative to repo, whereby the assets are not held on the balance sheet and the bank has no leverage.
“The TRS is an alternative to repo, requiring different documentation such as an ISDA CSA and not a Global Master Repurchase Agreement, and different accounting but the economic impact is the same and it doesn’t have leverage ratio,” added Boleslawski.