Risk South Africa rankings 2011

Newton's cradle demonstrates how energy travels through a row of touching metal spheres. Once the end ball is lifted and released, the energy of its impact travels through the row, kicking the last one away. A similar dynamic can be witnessed in the current financial crisis, with subprime mortgage defaults translating into structured credit defaults, then bank collapses, sovereign bailouts and – over the last 18 months – fears about the sovereigns themselves.

The spread of the crisis can also be measured geographically, leaping from one country to the next, with the vector for contagion often being the banking system, and the trigger for the latest bout of risk aversion being political squabbling in both Europe and the US. Despite being relatively remote from both markets, South African dealers are seeing the impact.

"Liquidity has become a scarce resource, bid/offer spreads have widened, interbank appetite has diminished significantly, and it's all being driven by offshore factors," says Stephen van Coller, chief executive of Absa Capital in Johannesburg. "There has been a huge sell-off in rates due to extreme risk aversion which has given us a very steep yield curve. The interbank market has been affected, which has impacted liquidity and the markets ability to de-risk. Bid/offer spreads have moved from two to four basis points at the beginning of the year to around 10bp in the last six weeks. In many markets we are now finding one-directional flow that has been very difficult to manage. It's a tough environment."

Absa Capital retained the top spot in this year’s Risk South Africa rankings 2011 with 16.5% of the overall vote, edging ahead of second-placed Standard Bank – just 0.3 percentage points separated the two institutions. In a close race, Rand Merchant Bank (RMB) finished third with 15.9% of the vote.

Absa Capital took first place in the currency products category, while finishing second in interest rates and third in the equity derivatives categories. It also claimed first place in structured products, while finishing second in both credit default swaps and commodities. The bank performed particularly well in the currency categories, coming first in both the foreign exchange options and forwards categories for US dollar/rand. Underlining its overall performance, the bank also came top of the risk management category.

The current woes of European banks is also filtering into the South African market. French banks, in particular, have been feeling the heat as a result of funding concerns and holdings of peripheral sovereign debt. Spreads on Société Générale blew out from 248bp at close of play on August 9 to 364bp on October 5, while its share price fell from €26 to €19.6. And with banks still under pressure, Markit’s iTraxx CDS index of European financials has been climbing steadily from 176bp on July 30 to 283bp on October 5.

With US investors shying away, the resulting shortage of dollar funding in Europe has meant the continent’s banks have attempted to secure funding via emerging markets, including South Africa.

“The cross-currency basis swap market used to trade at around +5 to +15 during the first half of the year but has since moved as low as -55 in recent weeks. That’s a result of European banks utilising the South African market - and certain other emerging markets, like Hungary and Poland, to obtain synthetic term dollar funding. The move has been considerable, but actual volumes were small,” says Eli Tyshynski, head of interest rate swaps trading at Standard Bank in Johannesburg.

Standard Bank performed particularly well in equity derivatives, coming top overall and winning first places in South African single stock options, exotic equity options and warrants. It also finished third overall in currency products and interest rates, coming first in interest rate swaps and US dollar/rand cross-currency swaps. It also topped the CDS and commodities categories.

Local dealers say the South African banks that have engaged in cross-currency basis trades with European banks have in place credit support annexes (CSAs) with low thresholds - meaning they are collateralised daily, and therefore have not taken material counterparty exposures to those foreign banks.

"We always trade interbank under a CSA, we wouldn't involve ourselves on a non-collateralised basis," says Andy Hall, head of global markets at Standard Bank in Johannesburg.

Banks in South Africa are starting to pay a lot more attention to collateral especially in the context of swaps pricing. Many banks now agree the overnight indexed swap (OIS) rate should be used to discount collateralised trades, rather than Libor – with the correct OIS rate determined by the currency of the collateral being posted. But this becomes hugely complex when a trade is backed by a CSA that allows the counterparties to choose from a list of eligible collateral. However, in South Africa, the absence of a local OIS market means all of the banks tend to use the Johannesburg interbank agreed rate to discount trades, and dealers recognise this has to change.

“Collateral is an issue that is high on everyone’s agenda, and there are many questions around what type of collateral is eligible under our CSAs and what discount rate should be used to discount swaps. It’s a complex problem. We know that collateralised trades should be discounted at OIS, but the South African market doesn’t have a local OIS rate, so the onus is on the industry to try to develop a solution. At the moment, there is a working group involving regulatory authorities and the treasuries of the various banks, and hopefully we’ll have something concrete by next year,” says Henry Collins, head of fixed income, currencies and commodities trading at RMB in Johannesburg.

RMB performed well across the board, topping the interest rate category while finishing second in currency products and – through its joint venture with Morgan Stanley – the equity derivatives category, with 16.8% of the vote. The bank performed particularly well in interest rates, topping three category: inflation, forward rate agreements and repurchase agreements. It also came second in a further three: interest rate swaps, options and exotics.

While offshore turmoil has affected South Africa, so too has the radically evolving derivatives regulatory landscape. South Africa, as one of the Group of 20 nations, agreed in 2009 to clear all standardised trades by the beginning of 2013. But, while the move towards central clearing is in full swing in the US and Europe, regulators in South Africa are still debating how central clearing will work.

A working group has been set up at the behest of the Financial Services Board, which oversees the country’s non-banking financial services industry. The group has been charged with proposing an appropriate clearing and settlement structure for the country. No formal proposal has yet been made, but dealers say it is a complex issue and many areas need addressing.

"It is being debated with local regulators how the main aspects of Basel III will be applied in South Africa while ensuring the domestic market adopts best practice. For example, we need to determine the benefits of a move to central clearing given the small number of sizeable local banks, and the extent to which a central clearer will reduce systemic risks," says Standard Bank's Hall.

"If you look at the International Organization of Securities Commissions' principles, a CCP should be able to withstand the default of its two largest clearing members. That may require significant individual contributions if shared among too small a membership. Also in South Africa, a high percentage of derivatives activity is with the corporate sector. Corporates rarely use clearing services due to their treasury structures and access to short-term liquidity, so it will be interesting to see how practice evolves between the price advances of centrally cleared derivatives against the convenience and bespoke characteristics of the OTC market," he adds.

Bankers are also urging regulators to take into account the liquidity and depth of the local swaps market. “There are a number of issues around the idea of central clearing that need to be ironed out first. One of the main concerns is figuring out if the liquidity and depth of the South African derivatives market actually warrants having a CCP and whether those volumes can be effectively risk-managed. It is likely that only the most liquid swaps markets will move to central clearing,” says Absa Capital’s van Coller.