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.
The Senate proposal to spin-off derivative dealing desks from banks will be decided upon as we enter the final stretch of the long roadmap to complete the financial reform overhaul in the US. Over the next couple of weeks the House and Senate will enter into conference to reconcile the key differences between the Senate’s “Restoring the American Financial Stability Act of 2010,” passed last week, and Chairman Frank’s House Financial Services bill, passed all the way back in December of last year, and this issue will be a priority to resolve.
As a taxpayer and a voter, I can see the main street appeal to this proposal, but for market liquidity it’s a bad idea and also raises the question of whether the other main tenets of the reform will actually work.
Forcing the banks to spin off their derivative desks will most certainly mean fewer swap dealers to provide liquidity. Earlier in my career, I was part of a swap subsidiary in the heyday when banks created swap subsidiaries (Remember Sumitomo Cap, Fujii Cap, Sakura Financial Products, DKB Financial Products?). From capital to legal structure to getting credit ratings, it was costly to set up these subsidiaries. Sure the large swap dealers will do it if they have to, but the smaller swap dealer that has the corporate end-user relationship may opt not to bother.
Who would also own these swap dealer affiliates? Surely the banks that currently are in this business will invest the capital, so the risk to the bank is still there, but ultimately it will be capped to the balance sheet and leverage of the swap affiliate. Again, this has to limit the market making capacity of the dealer and should limit liquidity.
Aside from the liquidity issue, it contradicts the structure of the reform, from the benefits of clearing, margining and capital requirements to the concept behind the Volker rule. The margin requirements should cover counterparty risk from one day to the next. The additional capital requirements are supposed to control leverage, which was really the root cause of the financial crisis, not the derivative instruments themselves. Spinning off the swap subsidiaries also begs the question of who would ultimately regulate them as well. Interestingly, AIG’s separate swap subsidiary was AIGFP.
Already the banks are making their case, and Chairman Frank has already publicly stated that he doesn’t agree with this aspect of the Senate bill, so hopefully common sense will prevail during the reconciliation process over the next few weeks.
Strange things are happening in the longer end of the USD LIBOR swap curve where USD Swap rates were trading below US Government bond yields at the end of March. In other words, swap spreads were negative for the first time in the 25+ years of the interest rate swap market. LIBOR, or the London Interbank Offered Rate, is an index based on the interest rate at which banks lend to each other in London in a particular currency and calculated from a panel of major banks http://www.bbalibor.com/bba/jsp/polopoly.jsp?d=1645. As most of the banks polled are of Single A or higher in credit rating, the LIBOR flat swap curve implies approximately a Single A bank credit curve, so a AA corporate should trade at LIBOR less a spread and maybe a weaker single A corporate should benchmark itself at slightly above LIBOR when looking to swap its own debt using the LIBOR swap market.
As the US Government credit rating is AAA, it has typically been trading at a lower yield than the equivalent USD Swap rate and as a spread over US Treasuries, so the USD Swap rate was always positive. The chart below depicts the historical data of 10-year Treasuries vs 10-year Swap rates, which over the last five years averaged 46 basis points and peaked almost at 90 basis points during the height of the financial crisis. The spread flirted with being 0 at the start of 2009 when the world was unsure whether the US was headed for a double dip or worst Depression 2.0. Since then, however, the economic picture has gradually improved, yet last month the spread broke the 0 floor and dropped as low as -9 basis points.
What is the swap market trying to tell us?
It could be a supply and demand factor due to a lack of new issuance—banks not lending or borrowers not borrowing—or due to the lack of corporates paying fixed in a steep yield curve that has forced down swap spreads. It’s probably a stronger reflection of the large debt load the US government needs to issue to pay for the bailouts and programs and a disconnect with the LIBOR markets where banks have access to liquidity and do need to lend to each other. Whatever the reason, something needs to give on the credit side, where either the swap curve should be reflective of BBB banks and the swap yields should be higher than the expected rise in US government yields or probably the reality that the US government should be downgraded to AA to reflect the huge and ever-increasing budget deficit and debt issuance, at least that is what the USD swap spreads are saying. The other time swap spreads were negative in a G7 currency was when Japanese swap spreads were negative to JGBs around the end of 2001—which was around the time S&P cut Japanese credit a notch to AA (http://www.nytimes.com/2001/11/29/business/s-p-cuts-credit-rating-of-japan.html?pagewanted=1).