19 December 2011

AFME, ICMA and ISDA publish paper analysing the impact of European sovereigns' collateral policies

The Association for Financial Markets in Europe (AFME), the International Capital Market Association (ICMA) and the International Swaps and Derivatives Association (ISDA) today announced the publication of a paper entitled “The Impact of Derivative Collateral Policies of European Sovereigns and Resulting Basel III Capital Issues”. The paper estimates European sovereign collateral policies may drive a significant percentage – approximately half - of the volume in the sovereign CDS market.

Adoption of two-way collateral agreements by European sovereigns would ameliorate all of the issues discussed in this paper and the Associations accordingly recommend that such a change in practice be given careful consideration.

As outlined in the paper, many sovereigns transact over-the-counter (OTC) derivatives on a regular basis (in addition, quasi-sovereign and para-statals are also frequent derivatives users). Nearly all of these entities do not post collateral on derivatives transactions, but their counterparties do post collateral to them. The use of such one-way collateral arrangements creates credit exposure in the banking system, in the form of credit valuation adjustments (CVAs), and significant liquidity issues for the dealer community.

Dealers routinely hedge the exposure arising from transactions with European sovereigns using CDS. In fact, under the current Basel III proposals the only way to reduce the CVA charge is to purchase single-name CDS. Preliminary estimates using data provided to AFME and ISDA by the “G14” group of dealers indicate that the notional amount of CDS required to hedge these dealers’ sovereign-related CVA would have been roughly $70 billion as of March 2011. By comparison, the net CDS outstanding on the entire European sovereign market as reported to the DTCC was roughly $143 billion. Such hedging may therefore account for as much as 50 per cent of the open interest in CDS for the European sovereign community.

The recently announced short selling regulation, which will be converted into technical standards by the European Securities Markets Authority (ESMA), permits European sovereign CDS to hedge financial contracts. The Associations, respectfully, strongly recommend ESMA respect the clear intent of the regulation, particularly as regards its identification of financial contracts as exposures that firms might legitimately hedge through CDS. The need for European sovereign CDS for hedging purposes is large and the inability of dealer firms to use European sovereign CDS in this context may create unhealthy concentrations of credit risk and reduce European sovereign access to the OTC derivatives marketplace.

Finally, the practice of not posting collateral creates an additional liquidity requirement for the banking system that runs to tens of billions of dollars. This liquidity need may constrain banks’ ability to undertake other business at a time when capital is in high demand.

The Associations’ paper follows research recently published by the European Capital Markets Institute (ECMI). Authored by Professor Giovanni Calice and entitled: “The Impact of Collateral Policies on Sovereign CDS Spreads” (view article), the research analysed a CDS contract with an asymmetric collateral agreement and obtains a straightforward pricing formula for the collateralised CDS. The study provided a preliminary understanding of the intricate interrelationships between asymmetric collateralisation, financial institutions CVA hedging needs through CDS, and the sovereign CDS market.

Full paper

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