Sovereigns and OTC Derivatives Clearing: the rules are a mess. We look at an excellent paper from BNYM.

Recently Bank of NY Mellon (BNYM) published a paper “Sovereigns in Search of Solutions:OTC Derivatives Reform: Direct and Indirect Impacts” reviewing the dilemmas faced by banks when executing OTC derivatives with sovereign counterparties. In this post, we look at some of the well argued points they make, but also urge you to read it for yourself.

Sovereigns, being thought of as risk free, have traditionally not been required to post collateral on their derivatives trades, but that is coming home to roost. By sovereigns it is meant to include “…central governments, sovereign wealth funds, state-sponsored pension schemes, debt management offices (DMOs), central banks and supranational institutions such as the International Monetary Fund (IMF), Bank of International Settlements (BIS), World Bank and the European Investment Bank (EIB)…” Dodd-Frank, European Market Infrastructure Regulation (EMIR), and similar efforts made by regulators around the globe require derivatives to be collateralized, CVA charges taken, and extra capital allocated for bilateral trades. The applicability of these rules to sovereigns is inconsistent and confused at best.

In Europe (and Singapore) sovereigns are exempt from clearing and reporting OTC derivatives. Yet Basel III requires bilateral OTC derivatives to allocate capital to cover potential CVA losses with no exemptions. However the paper noted that rules are in flux and ”…the latest Council of the EU draft of the Capital Requirements Directive (CRD4), which implements the Basel III recommendations in EU law, suggests that banks will not be required to set aside capital against potential CVA losses arising from exposures to certain sovereign Entities…” Sounds like the left hand lobbying the right hand.

Dodd-Frank’s ‘extraterritoriality’ provisions might ensnare trades done by foreign branches of US institutions with Sovereigns. Those rules “…classify non-US sovereigns…as financial end-users, and therefore subject to the Dodd-Frank Act provisions requiring exchange trading and clearing of eligible derivatives contracts, trade reporting and collateralisation of uncleared trades…” It’s a no win situation, especially if you’re a US bank.

The net result will be higher costs for Sovereigns. If Sovereigns insist on keeping bilateral trades, then the capital and collateral costs will be passed on. Should they opt to clear through CCPs, the extra collateral necessary will raise their costs. Of course, the collateral Sovereigns post will have to be safe, non-correlated paper or currency. We can imagine credit officers around the globe shrugging and, half-smiling saying “well, you wrote the wrong-way risk rules”. Some sovereigns have started posting collateral on their OTC derivatives exposures. We’ve heard that one line of argument used to convince them has been that without the collateral, banks need to hedge the exposure. CVA desks will do that by buying CDS protection, pressuring levels higher in the process.

The paper goes on to note that posting collateral, on bilateral and/or centrally cleared trades, will require some new infrastructure for the Sovereigns. Reconciliation, daily valuation, margin calls, collateral management and reporting may all be new to them. Reading in-between the lines, that sounded like an advertisement for BNYM, but hey, they are entitled.

A link to the paper is here.


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