By Joseph Neu
Following up on September’s notes concerning reassessing bank counterparty risk, we have further corroboration new analysis is being performed by treasuries, resulting in more attention on settlement risk.
CSA measures not enough
One big reason that counterparty settlement risk is such a issue is that it remains less than fully mitigated by ISDAs and Credit Support Annexes (CSAs)—now de rigueur with Dodd-Frank. You can set up collateral and exchange of margin to protect against changes in fair value of your position vis-à-vis a counterparty, but once you release your dollar payment to settle, say an FX trade on Friday, you still must rely on the bank counterparty to deliver euros on Monday. The risk that the counterparty might fail on Sunday (and since it is usually on a Sunday, think twice about settlement over a weekend) and not deliver your euros is settlement risk. Bilateral netting agreements can help but are cumbersome, and multilateral forms are still evolving.
Across various trades with counterparties, settlement risk can become significant. Therefore, corporate treasuries are spending more and more of their time managing it.
There are a number of ways they are doing this, but the primary mechanism seems to be setting limits for each counterparty, bucketed by tenors, above which they must either (1) move to net or other forms of “safe” settlement, or (2) stop trading with them.
SEF Fallout
Simply putting a stop to trading with a given counterparty might become less straightforward if murky language in Dodd-Frank defining Swap Execution Facilities (SEFs) is not interpreted in the right way. Speaking to The NeuGroup’s FX Managers’ Peer Group at its recent meeting his firm co-sponsored with Reval, FXall CEO Phil Weisberg noted that there is an interpretation of this language which would suggest that regardless of exemptions for certain transaction types, the entire market’s trading protocols are likely to change in order to live up to Dodd-Frank’s objective to promote fairness and transparency. One outcome of this is that corporate users of SEFs could potentially face scrutiny if they chose to transact with a particular counterparty rather than the counterparty with the “best” quote on any given transaction. So no settlement-risk considerations to take a higher bid are without repercussions. A bill (HR 2586) was introduced in the US House of Representatives in July calling for the CFTC and SEC to better define SEF requirements and avoid such adverse consequences, but the outcome is still in question.
Better Settlement Alternatives
Even without the potential SEF wrinkle, few corporates are in a ready position to shift business around to comfortably erase their settlement risk concerns. A few treasury professionals have noted how they have reshuffled their bank groups with the thought of bringing in new trading partners to diversify their settlement risk. Going outside of a bank group to trade for settlement risk diversification purposes, on the other hand, is something a few have thought of, but not yet acted on.
This leaves most treasury managers with the task of, as noted above, somewhat arbitrarily allocating trades and keeping the safe settlement option on the table. Allocation is arbitrary because, as one FX manager noted recently, “if all my main FX banks are orbiting around 300bps on the CDS-spread indicator, how do I pick which one is the bigger settlement risk?”
So wouldn’t it be better to just start safe settlement with everyone, just to be safe? Somewhere there is a pitch from CLS Bank that says essentially this, for FX at least: “CLS® Settlement eliminates the risk associated with foreign exchange (FX) settlement across time zones . . . With CLS, both sides’ instructions for an FX trade are settled simultaneously on a payment versus payment (PvP) basis and with finality.”
But it does not seem as if corporates have swarmed to CLS. There still are less than a dozen listed by CLS as of September 15. They include ADM, Carlsberg, Nike, Nokia, SKF, Tech Data, Total, Unilever and Volvo.
Perhaps there are alternatives out there that corporates are using instead. Raise your hand if you have found one. And surely there will be more coming your way soon.