Dollar/yen basis blows out as leverage ratio bites US banks

Dealers are blaming the impact of the Basel III leverage ratio for the recent 50% widening in the dollar/yen cross-currency basis as a shortage of market-makers causes a supply and demand imbalance in the cross-currency swap market.

Japan banks have massively expanded their foreign asset holdings in recent years as they look overseas in search of yield pick-up: according to Barclays, the amount of foreign currency loans outstanding – the majority of which are US dollar – has doubled from less than $400 billion to nearly $800 billion between 2010–15

Dollar bond issuance and deposit taking are the main routes for Japan banks to obtain US cash with the cross-currency repo and swap markets the two other avenues.

However, both of these areas have seen liquidity reduce from their main source – US dealers – after that group was hit by the imposition of the supplementary leverage ratio (SLR) in 2014. US authorities imposed a 5% ratio, which is significantly higher than the Basel III minimum of 3% – and this has consequently driven up the cost of dollars.

The result, according to a senior source at a US bank in Asia, is that the SLR is having an acute impact on pricing this year.

we have to err on the side of caution when offering products such as dollar/yen cross-currency swaps

"We had to start reporting leverage ratio numbers on our balance sheet from January and people are getting more concerned about disclosure. If we publish just 4.5% then the market will see we are behind so we have to err on the side of caution when offering products such as dollar/yen cross-currency swaps," he says.

The five-year dollar/yen cross-currency basis was minus 60 on January 1, but has since widened nearly 50% to minus 87 as of November 5. For a $100 million swap it is now 0.35 basis points more expensive to convert yen into dollars, which equates to $3.5 million annually or $17.5 million over the life of the swap.

"This is the widest the basis has been since 2012 when European banks' dollar funding pressures spread over to the dollar/yen basis," says Akito Fukunaga, chief Japan rates strategist at Barclays in Tokyo. "This time the widening trend started in July 2014. At that time it was minus 40. This is being driven by greater demand from Japanese banks to cross yen back to dollars as well as regulatory pressures on foreign banks to provide dollars via swaps."

A variety of factors contribute to pricing in the cross-currency basis market, with supply and demand being a major component. But now with dealers increasingly pricing in the cost of balance sheet required to offer a five-year swap and banks having less appetite for these structures the basis is being pulled wider than its normal range.

"Doing a cross-currency swap is costly and if dealers are taking into account the leverage ratio cost then the market price can quickly shift. More banks are taking into account capital valuation adjustment on these trades. From my point of view it's a mess to price just a simple swap," says a dealer at a European bank in Tokyo.

Capital valuation adjustment, or KVA, involves banks pricing in the amount of capital required for a specific trade over its lifetime. In general terms, the longer a trade the greater the capital it is likely to consume.

Different trading desks also have return hurdles they need to meet which may be constraining some dealers from providing cross-currency swap liquidity beyond a certain limit.

The upshot is that banks are scaling back activities that consume too much balance sheet at just the time banks in Japan need it the most; and the situation is likely to worsen before it gets better, according to Fukunaga at Barclays.

"It will go down in the near term, maybe to 100 next year. There needs to be more risk premium for dollar lenders at the moment. The current level isn't fair to lenders compared to their risk appetite but we may see stabilisation within six months," he says.