Bolstering sovereign debt sustainability: Integrating EMDE banks in the debt issuance and swap trading activities of MDBs

MDB liabilities

In general, the capital market operations (CMOs) of development finance institutions (DFIs) and MDBs play important resource mobilization roles.³ By crowding private investors into DFI and MDB debt, they leverage the equity capital provided by shareholders.⁴ In addition, the CMOs of MDBs play vital SDS roles. Because SGOs are based on pass-through pricing, the lower the borrowing cost of an MDB, the lower the lending rates of the MDB to its BMCs.

As frequent issuers, MDBs strive to diversify their funding products and investor bases. They issue global bonds and private placements, and they rely on private and sovereign entities to purchase their debt.⁵ This is where declining ODA poses a material risk: sovereigns provide both equity and debt. Therefore, if it does not have the financial resources to support an MDB’s general capital increase (GCI), a sovereign is highly unlikely to purchase the MDB’s debt. The logic is straightforward. On the one hand, an MDB’s GCI is not associated with a major financial commitment because paid-in capital represents a small proportion – say, 7% – of a GCI. So, when subscribing to USD 100 million of new shares, a sovereign is required to pay only USD 7 million. On the other hand, purchasing MDB debt, which usually trades close to par value, is associated with a major financial commitment. To purchase USD 100 million of MDB debt, a sovereign is required to pay about USD 100 million.

It is common for an MDB’s annual borrowing program to eclipse its total paid-in capital, and MDBs’ borrowing programs have trended upward. As a result, some sovereigns hold substantial amounts of MDB debt. With SDS in mind, any reduction in the sovereign purchases of MDB debt must be adequately offset.

Global bonds and private placements

To be adequately offset, any reduction in sovereign purchases must neither prevent MDBs from completing their borrowing programs nor force MDBs into higher funding costs. One rational approach is to replace redundant global bonds with private placements. This approach is rational for two reasons: first, sovereigns purchase only global bonds, while private investors purchase both global bonds and private placements; and, second, global bonds, which are also known as benchmark issues, are more expensive than private placements, which are often structured notes.

In the case of global bonds, redundancy can be determined from their function as benchmark issues. Assuming that an on-the-run USD curve must be maintained, there is no compelling reason for an MDB to issue more than USD 1 billion at each of the 2-year, 5-year, 7-year, and 10-year points. Therefore, within an MDB’s borrowing program, any issuance of global bonds exceeding USD 4 billion is redundant. Replacing such issuance with private placements improves overall borrowing cost. Moreover, the improvement can be accompanied by superior funding product and investor base diversification, as well as by high-impact CMD and DRM.

Private placements are executed on a reverse inquiry basis. They are purchased by professional private investors, and they can be complex products. However, since MDBs are interested in after-swap pricing, so long as an MDB can price, book, and value a structured note and the attached swap, the primary variable of interest is after-swap cost. Consequently, the availability of swaps that can be attached to notes is a key constraint on the issuance of private placements.

Integrating EMDE banks

EMDE banks are not typically on MDBs’ swap counterparty lists. Usually, when it is on the swap counterparty list of an MDB, an EMDE bank has been granted an exception for narrow operations; for example, exceptions have been granted in the case of local currency (LCY) operations.⁶ Such exceptions do not maximize either CMD or DRM. In fact, they worsen MDBs’ counterparty risk exposures, and they raise questions about fair access.

Because they are the borrowers, MDBs are predominantly focused on managing the counterparty risks associated with swaps attached to bonds and notes.⁷ Thus, an elegant solution – a solution aligned with the interests of all parties – is to establish a highly rated swap house that allows EMDE banks to offer MDBs note/swap pairs.⁸

Alignment and elegance are intertwined when the swap house requires no ODA, operates on non-concessional terms, and utilizes market infrastructure.⁹ Owned by private institutions, offering products to private investors, and clearing its swaps through central counterparties (CCPs), the swap house offers liquidity, transparency, and volume.¹⁰

This swap house is Spartacus.

Spartacus

Spartacus is designed to carry zero net market risk and minimal counterparty risk. Hence, it can have high leverage and deliver abnormal returns for shareholders.¹¹

The steps in the transaction process are the following:

1. An EMDE bank offers a triple-A MDB a note/swap pair, with the swap between the MDB and Spartacus converting the MDB’s exposure into, say, USD floating rate;
2. Simultaneously, the EMDE bank and Spartacus execute a mirror swap, ensuring that Spartacus carries zero net market risk;¹² and
3. Immediately, the swap between the EMDE bank and Spartacus is novated through a qualifying CCP, ensuring that Spartacus carries minimal counterparty risk.¹³

Every transaction follows this process. Spartacus’s only purpose is to integrate EMDE banks into the debt issuance and swap trading activities of triple-A MDBs. Its core mission is to lower MDBs’ lending rates to BMCs.

The integration facilitated by Spartacus has clear CMD and DRM benefits. Furthermore, Spartacus enables productive partnerships and reinvigorates faith in the multilateral system. Available to all EMDE banks on market terms, Spartacus ensures that every EMDE bank has the opportunity to lead-manage debt issues for MDBs.

This opportunity is dynamic in nature. CCPs offer central clearing for numerous products that are not mandated for central clearing. Also, they are interested in expanding their product offerings. Finally, they may be willing to combine existing CCP products to generate efficiency gains.

Conclusion

MDBs can strengthen SDS by lowering their lending rates to BMCs. Because MDBs’ lending rates depend on MDBs’ borrowing costs, MDBs seek ways of minimizing their borrowing costs. By integrating EMDE banks in the debt issuance and swap trading activities of triple-A MDBs, thereby helping MDBs prudently replace global bonds with less expensive private placements, Spartacus bolsters SDS while contributing to CMD and DRM. The development impact of Spartacus is immense because it requires no ODA, operates on non-concessional terms, utilizes market infrastructure, and works with all EMDE banks.