The Sovereign–Bank Nexus via OTC Derivatives

This chapter focuses on the role of collateral in the over-the-counter (OTC) derivative contracts between sovereigns and large banks. Specifically, due to the sizable volume of business (and associated revenue), most banks do not force sovereigns to post collateral when the sovereigns are out of the money on their derivative contracts. However, if banks are out of the money, they generally have to post collateral. The rhetoric about cutting the umbilical cord between banks and sovereigns will not get full traction unless sovereigns post collateral on their derivatives contracts with banks. Estimates of out-of-collateral positions are not trivial and thus cannot be ignored when discussing the sovereignbank nexus. The official sector is presently focused on appropriate haircuts (and risk weights) for the sovereign bonds; presently the flexibility allows for inconsistency (and thus overvaluation of the bonds) relative to other risk metrics (Hannoun 2011). This chapter suggests that there are par amounts (and not only haircuts to par) that need to be on the radar screens also

Introduction

As we have already seen in Chapter 6, present market practices for those using OTC derivative