Italy, the eurozone’s largest swap user, is keen to push through sweeping reforms to its derivatives laws but is besieged by delays. Other European countries have made more progress, while some are refusing to budge at all.
To see the digital version of this report, please click here.
To purchase printed copies or a PDF of this report, please email gloria.balbastro@thomsonreuters.com.
Italy may be well-established in its reputation as one of Europe’s leading taste-makers – high fashion, luxury cars and fine wine are in plentiful supply – but the country’s financial system is on somewhat less solid ground. Its fiscal deficit came in at 3% of gross domestic product for the second year running in 2013, while public debt soared to a staggering 132.6% of GDP.
But Italy is determined to attract foreign investors to its azure shores. And it emerged last year that the country’s lawmakers had penned a draft decree to introduce two-way collateral agreements that would see Italy post margin against its derivative contracts. The country’s uncollateralised swaps portfolio is estimated by some dealers to be as high as €40bn.
Currently, Italy does not have to post collateral because it enjoys special status as a sovereign. But this one-way agreement leaves Italy’s counterparties, namely dealers, with billions of dollars in funding obligations, which is reflected in the cost of Italy’s swaps.
A change in the law would make it cheaper for Italy to enter into swap agreements with dealers, and enable it to tap the mighty US dollar bond market for the first time in four years to meet its 2014 €470bn gross issuance programme. Cheaper swaps mean that Italy could issue debt in multiple currencies to diversify its investor base, and swap the bond proceeds back into euros using cross-currency swaps.
Alas, the Italian government never presented the decree to Parliament and now it is stuck in limbo.
New ground
Such a radical change to Italy’s way of doing business with swap dealers would undoubtedly be a complex legal affair, said Massimiliano Danusso, senior partner and head of the Italian international capital markets practice at Allen & Overy.
“This has never been done before, and posting collateral means taking assets from the Republic of Italy and transferring either the title or the rights of use. This explains the delay, as lawmakers decide which is best,” said Danusso.
An official reason was never provided for the setback, but Cozi Viviana, spokeswoman for Italy’s treasury department, said that perhaps there would be an update later this year.
“Of course, this is an important issue for us but it is not an urgent matter and we still have to find the proper legislation vehicle to introduce this innovation,” she said.
Certainly, Italy has more urgent matters at hand. Unemployment reached 13% in February, and some feel that derivatives legislation is not Italian lawmakers’ top priority.
Carlo Scotto, a sales manager at derivatives pricing firm SuperDerivatives, said that the instruments were still seen as “weapons of mass destruction” in Italy.
“This legislation is not a priority for 2014. In Italy there is a lot of turmoil around public expenditure and the amount of debt piling up – public finances are on politicians’ agenda at the moment,” he said.
Two-way CSAs here to stay
But despite the delays in Italy, two-way credit support annexes are slowly being adopted across Europe as sovereigns and government-owned entities acknowledge that they are no longer risk-free.
Portugal’s debt office agreed to use two-way CSAs in 2010, and a year later Ireland followed suit. A handful of other countries also use the agreements, including Hungary, Sweden, the Czech Republic and Latvia, while others are in the process of making the switch.
Denmark’s central government started negotiations last year with its swap counterparties to introduce new two-way CSAs. A large number have been concluded and negotiations with the remaining counterparties continue this year, said Lars Mayland Nielsen, head of government debt management at Danmarks NationalBank.
“Higher financing costs for the banks and new regulation of the financial sector mean that the central government can obtain better swap terms by introducing two-way CSAs,” he said.
The Danish central bank believes that more dealers will be able to quote competitively, which in turn will boost competition. Ultimately, the bank sees the switch to two-way collateral as in keeping with new European swap market regulations.
Even the Bank of England publicly announced in 2012 that it was introducing two-way collateral agreements due to the rising costs of derivatives transactions, which it acknowledged were partly caused by the one-way provision of collateral.
Who else needs convincing?
But not everyone is on board with the new train of thought. The European Union’s long-term lending institution, the European Investment Bank, is fiercely opposed to any changes to its collateral agreement with dealers, and is not open to negotiation.
Eila Kreivi, director and head of capital markets at the bank, denied that the bank was exploring the use of two-way CSAs and said many SSAs remained opposed. The EIB does not post collateral because of the possible liquidity impact on its balance sheet, according to Kreivi.
“Our portfolio is so directional that any impact would hit the entire portfolio in the same way,” she said.
Whereas a commercial bank has trades in all directions and benefits from netting, a bank like the EIB swaps everything into floating rate and mostly into euros, hence the directional nature of its portfolio.
Some dealers happily accept one-way collateral agreements and offer aggressive swap pricing in return for ancillary business, such as a lead bookrunner role on a bumper bond issue, say market participants.
But attitudes are changing, as SSAs accept the lasting impact of the financial crisis, notably the realisation that no entity is risk-free, and that dealers can turn away business.
“Many Triple A rated institutions [and countries] want to show their superiority in collateral agreements and of course everyone wants to do business with sovereigns, but that might change in future,” said Tom Meuwissen, general manager of the treasury at Dutch public sector lender NWB Bank.
NWB Bank has used two-way collateral agreements for a number of years and has reaped the benefits, including competitive swap pricing and improved collateral management.
Furthermore, the rise of capital charges under Basel III means that uncollateralised exposures are a headache that dealers would rather avoid.
“There is a combination of market pressure and changes to capital rules, which reflect that sovereigns are not entirely risk-free,” said John Wilson, head of over-the-counter clearing at brokerage firm Newedge.
“[Anyway], SSAs do not necessarily need to fund their CSAs in cash. They could even issue collateral in the form of their own debt to meet their obligation,” he added.
Upper hand
But the truth remains that some of the largest countries in Western Europe still have the upper hand when it comes to dealing with banks.
As one head of head of FX at an investment bank in London pointed out, the pool of counterparties for a country such as Italy is so great that even if a few banks do pull out of transacting swaps in protest at one-way collateral agreements, others would still be there.
“If they reduce their liquidity providers from 30 to 27, it’s not a huge issue. The bigger issue would be if a large player like Deutsche or Barclays were to say no.”
But even the withdrawal of UBS from the SSA business in 2012 has not had a material impact on sovereign adoption of two-way CSAs, said dealers.
In the meantime, banks such as the EIB are happy to stand firm.
“Some entities will hold out as long as they humanly can,” admitted the head of FX. “We were expecting more central banks to follow the lead of the Bank of England, but that has not been the case.”
