* Largest sovereign swaps user to post collateral
* Questions remain over how initiative will be funded
* Banks hope move will encourage others to follow
By John Geddie and Christopher Whittall
LONDON, Oct 25 (IFR) - Banks are hoping other reluctant public sector clients will match Italy’s move towards posting margin against its derivative contracts, creating a more balanced relationship that will make swaps business more viable under new regulations.
While the finer details are still being ironed out, the adoption of two-way collateral agreements with what has historically been the most prevalent sovereign user of derivatives would mark a major coup for the industry.
“It is a shift to the way that the market is moving. You have seen the agencies move that way, some of the supranationals are about to break rank, and eventually all of the sovereigns will have to change too,” said one head of sovereign, supranational and agency (SSA) origination.
Basel III has ramped up the cost of transacting unsecured derivatives, leading to banks relentlessly lobbying clients to move towards symmetrical credit support annexes (CSAs) in order to ease credit and funding constraints.
Some banks saw the costs of the business as too prohibitive; UBS decided to largely withdraw from dealing with SSA clients a year ago.
Others hiked transaction fees or refused to deal with lower-rated issuers, effectively barring them from foreign currency markets.
This has led to a trickle of struggling sovereigns such as Portugal and Ireland agreeing to post margin over the past few years, while quasi-sovereign issuers such as Germany’s KfW have embraced the change to obtain better swaps prices.
However, supranationals, like the European Investment Bank, which are the largest users of cross-currency swaps that become punitively expensive under Basel III, are still refusing to budge.
Italy’s lawmakers have hammered out a draft decree to update its collateral agreements, which has been tacked onto the budget law and is expected to be approved by parliament before year-end.
“[Posting collateral] is becoming an international standard, recommended by the IMF,” an Italian Treasury official told IFR.
Italy stated in a draft document seen by Reuters that the measure is necessary to reduce the credit exposure of bank counterparties, and allow easier and cheaper sales of government bonds.
It will also allow it to fulfil its desire to tap the dollar market, from which it has been absent for three years.
Its need to diversify its investor base is understandable. Analysts expect gross issuance of some EUR470bn-EUR490bn from Italy in 2014 at a time when there is a dwindling pool of European Central Bank cash sloshing around European money markets.
Increasing pressure from its banking group to sign swap agreements may also have played a role. The country’s notoriously large uncollateralised swaps portfolio - estimated by some dealers as being in the region of EUR40bn - has long been a thorn in the side of capital-constrained banks, which have taken increasingly aggressive measures to manage their Italian risk.
Morgan Stanley won grudging respect from rivals when it invoked a break clause to unwind USD3.4bn of Italian swaps exposure in late 2011.
Banks will be studying the fine print of Italy’s new documentation with interest.
Italy posting cash collateral on a daily basis without restrictions would provide dealers with the maximum amount of security, allowing them to lower swaps prices.
But the prospect of finding hundreds of millions of collateral when swaps positions drift underwater is an issuer’s nightmare, and explains why many have been slow to amend documentation so far.
Telling taxpayers an extra few billion euros will be added to the national debt to pay off derivatives contracts is hardly a vote-winner.
There are various halfway houses, such as posting government bonds that dealers can raise cash against in repo markets, or introducing mark-to-market thresholds below which collateral transfers aren’t necessary. But banks tend to push back against such compromises.
“If you’re a well-rated bank then credit, not funding, is your main concern. Posting BTPs is not a long-term solution,” said a debt capital markets origination head.
The Italian Treasury official said it was still analysing various solutions as regards the type of collateral it would post. What happens to its meaty legacy portfolio is also unclear.
“It will be a selective application [of collateral] to the stock/new issues,” said the official.
Either way, Italy’s openness to overhauling its swaps agreements is cause for cheer among banks, which hope it may presage a similar move from supranational issuers that have proved largely intransigent to date.
“It is a step in the right direction,” said the head of rates at a major bank. “It may encourage other SSAs to follow, but it’s not clear it will change the mind of EIB, which is the most important one.” (Reporting by John Geddie and Christopher Whittall; editing by Alex Chambers and Julian Baker)