The Association for Financial Markets in Europe (AFME), the International Capital Market Association (ICMA) and the International Swaps and Derivatives Association (ISDA) have criticised the collateral policies of European sovereigns for creating credit risks and damaging liquidity in the financial system.
Under current practice, the region’s governments do not post collateral on their OTC derivatives trading, including interest rate swaps, but their counterparties do post collateral. In a joint paper, ‘The Impact of Derivative Collateral Policies of European Sovereigns and Resulting Basel III Capital Issues’, the three organisations point out that the use of such one-way collateral arrangements create credit exposure in the banking system in the form of credit value adjustments, as well as liquidity issues for dealers.
The paper estimates European sovereign collateral policies may drive approximately half the volume in the sovereign credit default swaps (CDS) market, since dealers routinely hedge the exposure arising from transactions with European sovereigns using CDS. Estimating the cost of not posting collateral at tens of billions of dollars for the banking system, the three organisations argue this liquidity need may constrain banks’ abilities to undertake other business at a time when capital is in high demand.
In response, AFME, ICMA and ISDA are calling for the adoption of two-way collateral agreements by European sovereigns. The organisations also requested that the European Securities Markets Authority (ESMA) ensure that dealer firms are able to use CDS for hedging, warning that any move that would prevent this might create unhealthy concentrations of credit risk and reduce European sovereign access to the OTC derivatives marketplace. This warning is in reference to the fact that European policymakers have been considering a possible ban on the use of sovereign CDS in recent months.
“The CDS market for European Sovereign reference entities is an important hedging tool and it is very important that its use for hedging remains permissible under recent EU legislation,” states the paper.
The objections of the three organisations are driven partly by broader regulatory change. Basel III provides capital relief if positions are hedged with single name CDS – a factor that is likely to encourage dealers to hedge their exposure to sovereigns with CDS. However, the rules do not consider interest rate and foreign exchange products as valid hedges of credit value adjustment risk, and hence, do not lead to reduced capital charges. Instead, these are considered proprietary positions and thus attract further capital charges. The three organisations are determined to overturn what they see as a “serious error”. In the meantime, they point out that the application of this rule would have much less effect if European sovereigns posted collateral.
The three organisations also identified CDS spreads as a factor affecting the cost of borrowing for European sovereigns, suggesting that the practice of sovereigns not posting collateral for their derivatives contracts can influence sovereign CDS spreads, thereby potentially raising sovereign borrowing costs for certain countries.
“Adoption of two-way CSAs by European sovereigns would ameliorate all of the issues discussed in the paper and the associations accordingly recommend that such a change be given careful consideration,” said the document.
Basel III, the new global regulatory standard on bank capital adequacy and liquidity agreed by the Basel Committee on Banking Supervision in Switzerland, is expected to take effect in 2013.