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Basis Swap – how to convert your exposure

| 10-04-2018 | treasuryXL |

At the moment, there is a growing movement within interbank markets to replace all the existing interbank offer rates that are used to price a myriad of financial instruments. The motivation for this movement has been the revelation that these indices have been fraudulently priced by banks delivering inaccurate prices for the daily fixing. At the moment the markets are first looking at secured overnight lending indices – but these are not complimentary to all the existing instruments that regularly reference a longer tenor on an unsecured basis. These can lead to problems with the asset and liability management of a portfolio – not just for banks, but also for corporate clients.

So, what is a basis swap and how does it work?

A basis swap is an interest rate swap where both legs reference a floating rate – either in the same currency or on a cross currency. Examples would be a 3 month Euribor exposure against a 6 month Euribor exposure, or 3 month USD Libor versus 3 month GBP Libor. In a normal positive yield curve the interest rate for a longer tenor is higher than for the shorter period – 3 month USD Libor is 2.33746% and 6 month USD Libor is 2.47219%. There are 2 main reasons for the difference in price – the tenor is longer, therefore the risk of repayment is lengthened and the individual credit rating of the counterparty is also affected.

Before the financial crisis of 2008, basis swaps were traded, but not given much attention. Their primary function was for transforming the asset and liability management in the same currency. It was actively used in the cross currency market where a bank might raise long term funds in Japanese Yen, but needed to convert the proceeds into USD. Furthermore, the consensus at the time was that 1 master curve could be built to price all products – this used short dated deposits, 3 month interest rate futures and long date interest rate swaps to build the single curve.

This meant that a 6 month deposit was built on the basis of a 3 month deposit and a 3m v 6m FRA (Forward Rate Agreement) . In such an instance there would be no arbitrage possible and the market did not really look at the basis risk. But the basis risk was inherent and certain market players exploited this misconception – particularly banks that received fiduciary funding via Switzerland.

Today, there is far more awareness of the basis risk. 3 month Euribor is -0.329% and a 3v6m EUR FRA is -0.33/-0.31%. However the 6 month Euribor is 0.270% (we will leave you to do the calculation)

As a longer tenor has a higher interest rate (in normal market conditions) a basis swap referencing a 3 month versus 6 month payment would see the 3 month period being quoted as flat rate plus a premium, and the 6 month period being shown as a flat rate. A typical quotation for a 1 year EUR basis swap referencing a 3 month against 6 month Euribor would be priced around at about 5 -6 basis points premium. This means if you were to pay the shorter period of 3 months you would pay the base of 3 month Euribor plus 5-6 basis points every 3 months for 1 year, against receiving the 6 month Euribor flat every 6 months.

This product allows you to transform your position, but also gives insight into how the market sees the continuous 3 month and 6 month curves, together with their inherent basis risk.

An interest rate swap curve that references a 6 month floating leg, will normally be built from an interest rate swap curve built off a 3 month floating leg, with an adjustment for the 3m v 6m basis swap to reflect the higher price on a 6 month curve.

1 year to Brexit – the banking exodus?

| 09-04-2018 | treasuryXL |

If all goes as stated, then the United Kingdom will be leaving the European Union on 29^th March 2019. There has been fierce competition within the EU to entice banks away from London and to settle within the Euro zone. In London there is a fear that there will be a banking exodus – an industry that has prospered and made London a global centre. At till now banks have been able to sell their services into Europe via London, that this is envisaged to change. So, how are the major European cities faring in their campaigns?

What is at stake?

The scenarios of job losses are varied – 10,000 job in banking, 20,000 in further financial services. Others speak of job losses totaling more than 200,000. The large US investment banks retain more than 80 per cent of their European staff in London. The main target appears to be the Euro clearing role – a settlement service mainly in financial derivatives denominated in Euro’s that is now performed in London.

The Netherlands has certainly tried to attract interest from foreign banks and has many good qualities. Most of the population speak English, and there is a good infrastructure. Tax incentives are offered to qualified foreign workers, together with a global port in Rotterdam. The Netherlands Foreign Investment Agency is actively engaging with foreign companies, extoling the virtues of the country. Recently, Unilever took the decision to place its headquarters in Rotterdam – even though they have had a head office there for close on 100 years. Whilst there is already an appreciable physical presence of foreign banks on Dutch soil, there have yet to be any big announcements about a bank moving from London to Amsterdam or Rotterdam.

Germany, and specifically Frankfurt, have also been hard at work. The economy minister for the state of Hesse, claims that more than 20 financial institutions have chosen for Frankfurt. As of today, their names have not all been revealed. Frankfurt is an established financial centre, though discernably smaller than London. As well as banks, there are also regional corporate treasury centres, prime brokers, legal services and other ancillary groups.

Paris – that has been chosen for the European Banking Authority – is also in the picture but does not appear to be attracting the financial institutions. If banks follow the London model, then they would rather be closer to the central bank – the ECB – and that is headquartered in Frankfurt.

Relocation of the financial industry from London to Europe will be good for local employment. It is not just the direct banking industry that will be of benefit to the local communities. The support services are very significant and must also be factored into any equation.

With now less than 12 months to go till Brexit, the race will be heating up to woo the banks as the prize is very enticing and the gains to local economies very large!!

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State of the nation – the future looks bright

| 06-04-2018 | treasuryXL |

Last week, the Centraal Bureau voor de Statistiek (CBS) released their year end data for 2017 regarding the Dutch economy. The recovery is strong – for the first time since 2008 the Netherlands complies with 2 of the important Euro criteria at the same time; the government debt is below 60% of GDP and the annual budget deficit must not exceed 3% of GDP. Furthermore, Dutch GDP grew at an annual rate by 3.2% in 2017 – this is higher than in 2016 when the growth was 2.2%. This is the strongest growth since 2007. We take a look at the data and the contributing factors.

Debt

At the end of Q4 2017, government debt was reported as EUR 416 bn. This is 56.7% of GDP, compared to 61.8% in 2016. There was a reduction of EUR 18 bn in the total debt – the largest annual fall recorded. As recently as 2014, this ratio stood at 68.0%

Budget surplus

At the end of Q4 2017, the government had a budget surplus of EUR 8 bn – a surplus of 1.1% of GDP. In 2009, this was a deficit of 5.4% of GDP. Expenditure increased by EUR 7 bn in 2017, but this was offset by an increase in revenue of EUR 12 bn. Tax revenues increased by EUR 15 bn. There was additional income of EUR 8 bn from the sale of state shareholdings in ASR and ABNAmro among others.

Inflation

There was a rise in consumer prices – CPI showed an annual rise of 1.4% in 2017. This compares with a rise of 0.3% in 2016.

Labour

Wages in 2017 increased by 1.7% and unemployment fell in 2017 – at the end of 2017 the rate was 4.1%. Shortages of available labour are being observed in the market – employers have stated that they are finding it increasingly hard to find appropriate employees. The latest reports suggest that there are 1 million vacancies, but that employers are having difficulty finding qualified people. Most of this growth appears to be coming from the small and medium sized enterprises (MKB) – large organisations are still in a round of cost-cutting and down-sizing.

The report of the Netherlands looks very rosy, but international events could impact on the health of the economy. There are threats of trade wars; Brexit will impact on trade within 1 year; the EU parliament is asking for more money in the next budget cycle; the composition of the new Italian government could cause unrest within the rest of the EU.

The future does look bright, but caution is advised on the road ahead.