INTERVIEW | A groundbreaking permission for Denmark’s “flex bonds” as collateral for derivatives clearing at LCH Ltd is a big thing not only for the country’s own financial market. It could also point towards a future where more non-government backed asset types can be posted as margin for counterparty exposures and decrease the risk of cash droughts such as the UK’s mini-budget crisis in 2022. PostTrade 360° speaks with Capital Market Denmark CEO Anders Schou.
Denmark’s covered bonds market is something very special, and the recent final ‘go’ from UK-based derivatives clearing dominant LCH Ltd could be seen as proof. It appears to be the first time that bonds without the backing of a government make it onto the list of assets that are permitted for posting as “margin”, to guarantee a market participant’s fulfillment of counterparty obligations generated by derivatives positions. The change comes in tandem with the eligibility also of bonds from the United States’ famous mortgage institutions known as Ginnie Mae, Fannie Mae and Freddie Mac, which fill a somewhat similar function but where the ultimate backing by the US government is a key component.
“This is good for our capital markets industry, including our issuers,” says Anders Schou, CEO of Capital Market Denmark, a leg of the nation’s broad industry association Finance Denmark. “It is also good for the investors and households who both are our customers, as it should contribute to reducing the swings they face in their real interest rate upon the regular adjustments.”
Always on today’s menu
Pretty much all private housing financing in Denmark, as well as a sizable part of the commercial estate financing, is lent by four large dedicated mortgage institutions – against the borrower’s commitment of the housing as collateral. These institutions then issue covered bonds and sell these to institutional investors – whose safety is supported by rights to the underlying collateral in the unlikely case of a default. In Denmark, this market is so liquid, new bonds are initiated every banking day, and despite the country’s small size it hosts one of the world’s largest covered bond markets. (This recent report by the Danish central bank gives detail on the market, where eight market makers also play a central role.)
Through the 200 years or so that this market has existed, no issuer ever defaulted on a bond. The AAA rating that the bonds come with has taken them to a trust level similar to that of sovereign debt. A large part of the covered bonds are 30-year investments, making them favoured by pension funds. The flavour that has now been permitted for margining at LCH is at the opposite end of the curve, with shorter interest rate adjustment. With these short terms, they show very low price volatility, helping them qualify as the high-quality liquid assets that a clearinghouse must require them to be.
Could help prevent crises
The high liquidity of these Danish flex bonds makes them popular not only with the investor institutions but also a favourite asset type for banks with market making and other trading actors who now and then need to convert assets for cash at short notice. In some situations, a market participant’s need for cash may be prompted by an urgent call from a clearinghouse for “variation margin”, to cover for a value decrease in a counterparty position, for example a swap, that is cleared there. In times of market swings, where this forces many holders to sell fixed-income instruments from their inventory at the same time, this could press down the bond market price and contribute to a drying up of cash in the market, making the problem spiral. This happened in the UK’s near-disastrous “mini-budget crisis” of September 2022, when the market for short-term government debt securities known as gilts collapsed, as pension funds were forced to sell them while buyers weren’t there. (Public bodies eventually stepped in.)
“For many investors who manage collateral towards LCH, it will be interesting to hold these covered bonds rather than cash,” says Anders Schou.
1 trillion DKK comes into play
This could make them more attractive to international derivatives market participants. Many Nordic banks already hold big inventories of them, for the possibility of selling when needing cash. Their advantage could be that they could keep them even in crises.
“Next time we see rates jumping up, pension funds who have a lot to do with LCH could be able to use these bonds as collateral, not needing to sell to the same extent.”
Denmark’s four large mortgage credit institutions are Nykredit/Totalkredit, Nordea Kredit, Jyske Realkredit and Realkredit Danmark. Their total of covered bonds amounts to about 3,500 billion DKK, of which roughly 1,000 billion is of the adjustable-rate type that is now in scope for the collateral eligibility at LCH Ltd. These usually have a maturity of 1–10 years, typically 3 or 5 years, while the borrower has the loan on a longer term such as 30 years. The majority of the Danish covered bonds are held by domestic actors, though the new utility for collateral purposes could possibly increase their attraction with derivatives-market participants also internationally.
