over the merits of offloading counterparty credit risk from uncollateralised derivatives trades to mitigate increased capital charges under forthcoming regulations.
Basel III will require banks to hold more capital against counterparty credit exposures from derivatives that are not passed through central clearing, while charges will be particularly punitive for trades not governed by low threshold credit support annexes.
This could be another cost that filters through to uncollateralised counterparties, which are already having to contend with the increased cost of funding and credit charges being incorporated in longer-dated swaps prices.
As well as the large population of corporates that are not prepared to tie up liquidity by signing CSAs, sovereigns and supra-nationals with one-way CSAs could also see prices rise as a result of the capital charges regulators are imposing.
'Market risk has almost become a second order component when pricing uncollateralised derivatives,' said one senior derivatives banker at a European house. 'You're talking about fractions of basis points differential on the market risk side, compared with multiple basis points on the capital and credit effects.'
Risk transfer seems like the obvious solution: repackaging these counterparty credit exposures and selling them on to investors that have the appetite for this type of risk most likely institutions not subject to the forthcoming Basel III capital rules.
This should grant the dealer capital relief, which some argue could be reflected in a lower swap price for clients. A handful of counterparty risk securitisations were executed pre-crisis, but only UBS is understood to have placed a transaction since.
However, the mitigation of counterparty credit risk from bank derivative portfolios is viewed very differently across the dealer community.
'We have an extensive, diversified portfolio of different names and tenors across our corporate business. This enhances our overall risk profile and makes us less likely to hedge specific names and deals that some banks need to,' said Gary Cottle, global head of corporate risk solutions at RBS in London.
'How will customers interpret a bank taking credit exposure to them, repackaging it and then selling it on? That's a different approach to relationship banking compared with an institution that will take the credit exposure through the term of the relationship,' added a head of corporate derivatives sales at a European bank.
Some speculate that only dealers with smaller or more one-way corporate portfolios will look to repackage counterparty risk. The senior derivatives banker presents a different view, highlighting the potential for these types of transfers to reduce costs for non-CSA counterparties in the new capital regime.
'This won't be our mainstream business, and it shouldn't be thought of as shying away from taking uncollateralised risk we'll continue to be in the risk game,' he said. 'But we think there may be mechanisms for optimising pricing for corporates. We don't want clients to be in a position where access to markets is impaired because of regulatory constraints creating capacity issues within the banking book.'
The question is how best to repackage this risk. Contingent credit default swaps are sometimes used for hedging against counterparties without single-name CDS, but this nascent market remains fairly illiquid. Securitisations of counterparty risk are more expansive, with dealers looking to cap exposure to as many as 500 underlying corporates. But executing these transactions can be desperately tricky in practice.
'In reality, it's very difficult to securitise what is a volatile asset in terms of the mark-to-market over time, and formulating mechanisms to allow for the substitution of illiquid assets over time is difficult to achieve,' said Stephen Nurse, executive director in JP Morgan's investment banking credit portfolio group in London.
Dealers believe investor appetite exists for this type of risk, with yields likely to reach well into the double digits, while the dealer could receive as much as 90% capital relief for its part. However, dealers agree that structuring and placing these deals can be fiendishly difficult, and the senior derivatives banker indicated that other mechanisms might bear more fruit.
'We're looking at it for a more continuous de-risking mechanism that would enable us to pass on pricing benefits to clients as we go,' he said. 'Clients could invest in a fund, which in turn invests in the corporate derivatives exposures. Theoretically, it's no different to buying a corporate bond, except the notional is going to fluctuate with respect to the underlying derivatives.'
Others say they continue to explore smaller, bespoke structures to offload counterparty risk, whether it's through CCDS or issuing credit-linked notes that would broadly mirror the cross-gamma risks in the derivatives portfolio. Above all, though, ensuring the structure will count as a hedge under Basel III, and thereby secure capital relief, will be a primary concern for dealers.
'Basel III is a moving subject, but based on the latest rules we think it is going to require more capital for banks to hold against counterparty credit risks, and therefore prompt more of this type of activity,' said one dealer.
In the meantime, most dealers are concentrating on the more traditional options available to a credit value adjustment desk. Restructuring can be particularly effective for trades that are heavily in the money for the dealer, said Nurse at JP Morgan.
'If the trade can be restructured to reduce the profile of the mark-to-market over time, a dealer can free up some of the CVA reserves it has to hold against the position,' he said. Other routes include encouraging counterparties to sign up to low or zero threshold CSAs, or working with clients to identify assignments among their dealer relationships to optimise for better netting sets.
'We have various tools at our disposal. Assigning trades produces the best results in economic terms, while some clients will agree to restructuring trades in a way that suits both parties. Towards the bottom of the list would be securitisations,' said Nurse.
(Christopher Whittall is a senior reporter for IFR in London) Keywords: COUNTERPARTY RISK/HEDGING
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