Asian sovereigns might be better off centrally clearing over-the-counter derivatives trades regardless of statutory requirements, because the higher pricing charged on non-cleared, bilateral trades by bank counterparties is likely to outweigh clearing costs.
While it remains unclear whether sovereign institutions will be required under the US Dodd-Frank Act to clear and report OTC trades through a central counterparty (CCP), they will likely face higher costs from trading them via banks anyway, notes a recent report* from BNY Mellon.
This is because, under Basel 3, banks that trade swaps with these sovereign entities will likely incur higher collateral costs on non-cleared trades so will seek to recover such cost through pricing the trades so high as “to the detriment of the sovereign”, says Jai Arya, Singapore-based head of the sovereign institutions group at BNY Mellon, and the report’s co-author.
BNY Mellon defines sovereign institutions as including central governments, sovereign wealth funds, state-sponsored pension schemes, central banks, debt management offices and supranational institutions.
Non-US sovereign entities are regarded as “financial end users” under Dodd-Frank and are also caught because of the extra-territorial implications of the Act. This means, for example, that once a non-US sovereign institution trades an OTC swap with a US swap counterparty they would also be required to clear and report the trade through a CCP. If they do not clear, they will have to post collateral on bilateral trades that remain in the OTC space.
While theoretically non-US sovereigns could avoid using US counterparties, doing so would have a very negative impact on liquidity, risk management and ultimately pricing, says Arya. A market survey from the International Swaps and Derivatives Association in 2010 found that the largest US-based derivatives dealers account for 37% of the global total notional outstanding amount of derivatives.
Governments and central banks use OTC derivatives to manage the duration and currency profile of their liabilities, notes Arya. And sovereign investors such as SWFs and state pension schemes are also extensive users of OTC derivatives for implementing investment strategies and hedging exposure. “We do not expect they will choose to curtail their derivatives activities,” he adds.
The potential for sovereign entities not being exempted from the requirements under Dodd-Frank has assumed a new level of complexity. This is because some Asian regulators are considering exempting sovereigns and central banks from outside their own jurisdiction, subject to certain conditions.
For example, the Hong Kong Monetary Authority said last week that it would consider giving an exemption on reporting and clearing to sovereign institutions under the city’s proposed OTC derivatives regime – subject to reciprocity.
Asked whether central banks would consider central clearing to be a cheaper option than posting collateral on bilateral, non-cleared transactions when trading swaps with US counterparties, the HKMA’s Esmond Lee says many factors need be taken into account.
“Nevertheless there is also the limitation that some structured products are not eligible for centralised clearing at this moment,” adds Lee, executive director for financial infrastructure. He is in charge of building the trade repository in Hong Kong for OTC reporting.
Under Basel 3, trade exposures to a qualifying CCP will receive a risk weight of 2% when calculating the capital charge for counterparty credit risk, a low risk weight set as an incentive for global regulators to encourage banks to centrally clear OTC trades. By contrast, exposure to non-approved CCPs or non-cleared, bilateral exposure would generally draw a minimum 20% risk weight.
* OTC derivatives reform: Direct and indirect impacts