Issuers face swap market hurdles in the year ahead

The effect of Donald Trump’s second stint as US president is set to be a recurring theme for capital markets in 2025, with expectation high that he will pursue deregulation, freeing up capital and boosting the presence of US banks in financial markets — or at least, that was the message US bank CEOs were keen to convey after his November 5 election victory.

Elsewhere, optimism in UK and European banking feels less certain. The European Commission, convinced that better capitalised banks are a strength, not a weakness, and it remains committed to implementing the Basel III endgame.

Those regulatory shifts will affect the cost at which banks can provide derivatives products, such as new issue hedging swaps, to issuer clients such as supranationals and agencies, directly impacting their cost of funding.

But when it comes to transacting derivatives, one UK liability-driven investment (LDI) manager told GlobalCapital that a handful of US investment banks had long been the “most aggressive” when competing for business, while the standing of European banks had shrunk. The prevailing regulatory winds threaten to exacerbate that trend.

The LDI manager, who uses interest rate swaps as part of his firm’s investment strategy, singled out Goldman Sachs and Morgan Stanley among the counterparties that most consistently show competitive IRS prices in large, executable sizes.

“We’ve found that a lot of other banks no longer like to take risks on their books,” he says about a trend that emerged after the global financial crisis.

“The amount of risk capital at some of the UK and medium-sized European banks has become pretty limited,” he adds, while also mentioning a large European bank had “lost a lot of its risk capital” in recent years.

Meanwhile, requesting a swap quote from a large US bank does not guarantee a competitive price, he points out. He names one US bank that he thinks had “never been great in pricing and always traded off the back of their franchise”.

But elsewhere, other end users of interest rate derivatives tell GlobalCapital that European trading desks can compete with their US peers on swap pricing.

KfW, a major player in interest rate markets as it swaps much of its €80bn-equivalent annual bond issuance, said it found that some European banks, as well as some Asian banks, offered “similar capacities” to US banks when executing derivatives.

A second issuer says it is a case of wait-and-see with regard to how the Basel III endgame shapes banks’ risk capacities.

“Our understanding is that Basel changes will be implemented gradually, allowing banks to adapt to the new requirements,” he says. “But the fact that some firms in the US have been lobbying against the new [Basel] rules, partly on the grounds of derivatives, shows how far the reach could be.”

It has been business as usual for derivatives business in 2024, according to KfW. The issuer regularly visits the swap market to hedge euro bond issues which can be as large as €6bn.

“For the bigger swap executions, we organise an auction method and it generally leads to a very attractive price,” says Markus Schmidtchen, head of treasury at KfW.

Swaps are executed at the time of issuance, with fixed rate interest cash flows swapped to floating, which for KfW is typically six month Euribor.

KfW does not use hedging for all of its new bond issues: “Generally, short-term issuance up to one year is left in a fixed rate format and is not swapped,” says Schmidtchen, “The shorter the maturity, the less market risk and it does not require an interest rate hedge.”

The bigger the transaction, the more bank counterparties are placed in competition. Allocations are then split between banks based on price but are also subject to the issuer’s risk appetite and limits with each counterparty.

The pool of competing banks shrinks when KfW brings a foreign bond issue to the market. “There are fewer counterparties that are able to digest cross-currency swaps in large volume in comparison to single-currency swaps counterparties,” says Schmidtchen.

KfW runs a global dollar benchmark bond issuance programme, swapping about two-thirds of what it issues into euros using cross-currency swaps, though it varies depending on requirements. It also offsets some of its dollar bond cashflows against assets from its export subsidiary KfW IPEXbank.

The agency also raises funds in several other currencies. It is by far the largest foreign issuer in sterling and Australian dollar bond markets, for example, with proceeds always swapped to floating rate euros.

Cross-currency interest rate swaps are an important tool for issuers. They are primarily used to hedge interest rate risks, though also serve to hedge foreign currency risks, which arise from cross-border bond issuance.

Yet they differ from single-currency interest rate swaps in two important ways. First, there is a physical exchange of the principal amount between counterparties. Second, cross-currency swaps are not cleared at a central clearing counterparty (CCP).

As a result, they can incur hefty credit, capital and funding valuation adjustments for trading desks — commonly referred to under the umbrella term XVA (cross-valuation adjustment) charges — meaning some banks tend to be less competitive than others when pitching for the business.

Historically, some SSA issuers, such as the European Investment Bank (EIB), requested a breakdown of the XVA charges embedded within a bank’s swap quote. But Schmidtchen says KfW does not seek specific XVA breakdowns and instead cares only about the final all-in swap price.

He highlighted that XVA charges are counterparty-specific and contingent on several factors including outstanding derivatives business and credit ratings, which vary by issuer.

Credit support annexes (CSA) are one tool SSA issuers use to mitigate the costs incurred in cross-currency swap execution. Most SSAs have two-way CSAs with banks, which means the side of the trade that is out of the money must post collateral to the other. The EIB is a longstanding outlier as it only has one-way CSAs in place, meaning only one party in the swap need post collateral when out of the money.

Sovereign, supranational and agency issuers traditionally argued for one-way CSAs on the basis that they should not face the expense of running an operation to post collateral to a counterparty with a worse credit rating than them. Though SSAs are often rated triple-A, investment banks are not.

“KfW follows most of the market standards for swaps derivatives business and has symmetrical two-way CSAs in place,” says Schmidtchen. “We try to follow the market standard where possible because it generally results in lower costs, meaning lower prices.”

The agency is exploring new ways to make savings in its cross-currency swap business.

“We are considering becoming a member of LCH SwapAgent,” Schmidtchen tells GlobalCapital. “Most financial institutions, especially investment banks, are already using the SwapAgent service and it would allow us to make savings on the operational side.”

While LCH SwapAgent does not have the same reach as central clearing, it does offer similar advantages such as standardisation on CSAs, dispute resolution, documentation and netting of cash flows — and where KfW leads, other SSA issuers often follow.

The transition from Euribor to €STR (euro short term rate) as the euro benchmark interbank rate occurred in January 2022 — but issuers tell GlobalCapital the change is far from complete.

The legacy benchmark rate Euribor remains in operation and is where most liquidity is pooled in the interest rate swap market for maturities of two years and longer.

Nederlandse Waterschapsbank (NWB), a Dutch public sector agency, tells GlobalCapital that it favours swapping new bond issues to €STR and may consider swapping maturities of up to five years against the rate, liquidity permitting. But beyond five years, the €STR swap market becomes more limited and Euribor is the floating rate of choice.

KfW typically swaps its new bond issues back to six-month Euribor. “We are observing the €STR market frequently,” says Schmidtchen, “But liquidity is by far bigger in the Euribor market for the longer maturities that are most relevant to us.”

An exception is the cross-currency swap market where €STR has become the dominant reference rate after the euro/dollar interbank standard moved to Sofr (Secured Overnight Financing Rate) against €STR in 2023.

“We did wonder about volatility between €STR and Euribor,” says KfW’s Schmidtchen, “But there has been no drawback in swapping back to Euribor for KfW and the pricing is in general very attractive, though it’s possible that for smaller institutions there is a pricing difference.”

Whether or not €STR will ever fully replace Euribor in the future is an open debate and set to continue in 2025 and beyond.

As KfW told GlobalCapital, it is understandable that many borrowers — especially small and medium-sized institutions — continue to favour a forward-looking reference rate and explains the endurance of Euribor in the euro swap market and the expansion of term Sofr in the dollar swap market.

Central counterparty clearing turned into a key battleground after the UK voted to leave the EU in 2016, throwing up a number of legal and regulatory uncertainties over the future location of euro swap clearing.

The European Central Bank previously took legal action, based on systemic risk concerns, to try and force clearing into the eurozone but lost the case in 2015.

In 2023 the European Commission proposed an amendment to the European Market Infrastructure Regulation (EMIR) to force some institutions to clear a minimum amount through an EU-based clearer.

But several industry groups, including buy-side associations, have warned about the costs to end users of being forced to shift their clearing business — LCH remains the dominant clearer and serviced around 90% of swap clearing business as recently as 2022.

While SSAs are not subject to EMIR regulations and can continue to transact bilateral trades, many choose to comply because following the market standard tends to be more cost-efficient.

Consequently, SSAs are likely to keep a close eye on regulatory developments. A key date in 2025 will be June 30, when the equivalence status the European Commission (EC) temporarily granted UK central counterparties, such as LCH, is set to expire.

The potential costs to end users arise from the Eurex-LCH CCP basis market. “While we are not obliged to clear through Eurex we do monitor the basis between LCH and Eurex,” says KfW’s Schmidtchen.

Taking a simple example, an issuer enters a new swap where it receives a fixed rate and clears the trade on Eurex. At the same time, the opposing counterparty bank clears its side of the trade on LCH.

The dealer will then use the Eurex-LCH basis market to smooth out the risk between the two different clearing houses and could save initial margin costs on trades that straddle the two CCPs.

“If the basis becomes too wide then we may decide not to clear and instead will trade on a bilateral basis,” says Schmidtchen.

NWB says that it also monitors the basis but would not trade it bilaterally if it found it to be punitive.

A third issuer said that being in a position to execute the basis swiftly was key. “The [Eurex-LCH CCP] basis tends to be very illiquid,” says the source.

For clients wanting to see attractive Eurex-LCH prices that are closer to mid-market, you have to have good communication with dealers and a readiness to execute quickly, he says.

“The most important thing is that the dealers know that you are able to trade,” he says. “Then if they do come to you with a price, you must act quickly. It might not be the trade you want, or the exact tenor you want, but if a good opportunity presents itself then don’t hesitate.”