Although final rules for Dodd-Frank have a ways to go and Basel III capital requirements are years away, the market is already reacting. Prices on longer-dated cross currency swaps varied by 60 basis points, between the high and low price, according to one Swap Dealer. In normal times, the range would be between three and five basis points.
What is driving this? Swap dealers are beginning to adjust their models to include risk adjusted capital requirements as it becomes clear that higher capital requirements are right around the corner. This, coupled with volatility in currencies, illiquidity in long-dated cross currency basis swaps and increased bank credit spreads, has caused more than a tenfold increase in costs as many of these factors will be approached differently from bank to bank.
On a related note, another company reported that the turnaround time to get quotes on longer-dated Fx options was taking five minutes or longer, rather than in seconds, as they had been provided in the past. Swap dealers seem to have less flexibility in using swap credit lines and either need more time to analyze the credit impact or, if close to breeching a credit line, need time to get proper credit approvals. In years past, the head of the Swap desk had some authority to go over a credit line in the event of an emergency.
One could argue that finally banks are simply pricing in the true credit risk to their corporate counterparties now, resulting in different prices on the same instruments. As the capital requirements for corporate credit risk is higher than for banks and sovereign entities, the bid offer for corporates should generally be wider, all else being equal.
This will be the way of the world post Dodd-Frank as dealers will be steered towards markets where they get the best return on capital, which most likely won’t be from un-cleared trades with non-financial corporate counterparties.