BSP eyes benchmark curve using swaps curve

IN a bid to further strengthen the Philippine capital market, the Bangko Sentral ng Pilipinas (BSP) is eyeing to build a benchmark curve using the swaps curve.

“There’s a lot of work to do in capital markets ... [we need] a good, reliable benchmark yield curve,” BSP Governor Eli Remolona Jr. told reporters in an event on Wednesday.

Remolona noted that there are “kinks” in the curve, and these kinks are quite unusual.

He explained that normally, if there’s a kink, it’s easy to exploit for profit through arbitrage. By taking positions on both sides of the kink, money can be made quickly.

“But somehow the kinks are so robust, they don’t go away,” Remolona said.

He also stressed the possibility of inadequate liquidity in the yield curve. This could be attributed to their ambitious strategy of assigning market makers at different maturities.

However, Remolona said that this approach hasn’t proven effective, as the bid-ask spreads remain wide, signaling a lack of liquidity.

The swap curve is becoming the dominant benchmark yield curve in European financial markets, often serving as a reference for some government bonds.

The European government has started utilizing interest rate swaps to handle their risk exposures.

Since October 2001, the French government has employed swaps to reduce the average maturity of its debt, while the German government uses swaps to decrease its interest costs.

The participation of governments in the interest rate swap market has typically limited euro swap spreads. As the spread widens between government yields and swap yields, governments are inclined to engage in receiving fixed rates in the swap market.

However, due to the current setup of the swap market, liquidity is not as resilient during market stress compared to the more extensive government securities and futures markets.

“I think maybe my proposal, and I’d love to discuss this, is to do what Europe did ... in Europe, when the Eurozone was starting, the markets, the government markets were fragmented,” Remolona said.

“So without any government initiative, without any central bank taking the lead, the swaps curve emerged as the benchmark curve. Maybe that’s the way to do it now,” he added.

The BSP chief emphasized that with swap contracts, you have less vulnerability to price fluctuations compared to holding government securities.

He explained that swaps involve net payments between fixed and floating rates, reducing your exposure to price changes.

“If we had a swaps curve, maybe you need to make markets, maybe just one maturity, maybe the five-year. Maybe that’s going to be good enough,” Remolona said.

“The benefits of it are that swaps can have various durations, ranging from five years to as short as overnight. So, when that market becomes active, a curve will emerge,” he added.

Instead of just having the government securities (GS) curve, Remolona said that there will be a swaps curve, which is equally effective as a benchmark.

People can then price various instruments against that curve, such as corporate bonds or mortgages.

However, despite it being seemingly easy to implement, like the master agreement, which is designed to be universally applicable, particularly for short-term regular swaps, Remolona stressed that it didn’t work for the Philippines for some reason.

“We used to do swaps quite a bit, but somehow they disappeared,” Remolona said.

“So I would like to revive the swaps market, the interest rate swap (IRS) markets, and insist on the market making at least the five-year maturity, which is the sweet spot for fixed income securities, for corporate bonds, for derivatives contracts so maybe that will work,” he added.

He then noted that the short end remains problematic, pointing out that there’s a lack of a robust “repo market” to anchor the short end.

Despite having the Global Master Repurchase Agreement, a supposedly straightforward and widely accepted solution, its implementation hasn’t been successful in this context, and the reasons for this remain unclear.

“We don’t know exactly what the problem is. We’re looking into it along with our own lawyers. The issue seems to be with the annex,” he said.

“The main contract itself is fine, but people insist on attaching an annex, and that’s where problems arise with the annex,” he added.

Remolona said that they aim to implement this within his term.