Swap me up before you go, go May 28, 2011 at 12:12 pm

FT alphaville suggests that a consequence of the CFTC proposed rule whereby sovereigns (except the US, naturally) will have to post collateral to US swap dealers on OTC derivatives is that US swap dealers won’t do many trades with sovereigns. They are of course right. The large European, Asian and Latin American debt management offices will not post collateral at the whim of the Americans – or anyone else.

Should they (and indeed the US government) be obliged to post? Well, it depends. If they had to, they would have to find the money from somewhere, and that would increase their levels of debt. On the other hand, one way CSAs, whereby the dealers have to post collateral to the sovereign but not vice versa, are a liquidity drain on the banking system.

The clinch argument for me, though, is CVA. Uncollateralised derivatives create a big CVA. (See here or here for a description of CVA and how it arises.) Basel 3 will require banks to hedge their CVA well or take capital against it. Critically this includes CVA from sovereign transactions. The way you hedge CVA is to buy CDS. Thus when you see a picture like these two from the Alphaville post:

5 Biggest Increases in Net Sovereign CDS

5 Next Biggest Increases in Net Sovereign CDS

What should ask yourself is ‘how much of this increase in CDS trading is caused by CVA hedging?

The prior post suggests that there is only $4-30 Billion net notional of CDS on even the biggest countries. My guess is that the major swap dealers need a good deal more liquidity than that to hedge their collective CVA position without moving the market.

The Basel 3 CVA rules, then, are a huge shot in the foot for governments. (A 50mm shell in the foot, maybe.) By forcing banks to hedge their sovereign CVA, they have increased the demand for sovereign CDS. That drives out spreads, which in turn increases borrowing costs for governments. The problem could be largely solved if sovereigns would agree to post collateral – but they won’t.

2 Responses to “Swap me up before you go, go”

  1. Dear David – in the third paragraph of your post (in brackets) the second link is wrong: it reads


    while in fact it should be just

    http://www.stanford.edu/~duffie/Chapter_09.pdf (it works this way and points at the right document).

    Somehow the URL of your blog got in front of the link address – and messed things up a bit, I guess.

    Thanks for the blog, by the way – I greatly enjoy your fresh points of view, as displayed in your posts, and your analysis that’s both insightful and incisive.

  2. Victor – this is actually a browser bug. If a link is left as http://www.a.com, then some (but not all) browsers render it as http://www.rivast.com/www.a.com rather than the correct http://www.a.com. The fix is to put the http:// explictly in the link. *sigh.

    Thank you.