On the 15th of June 2022, the Deputy Governor of the Bank of Uganda (BOU) officially launched Tradeclear or Umbrella Guarantee Facility in Kampala, Uganda. Uganda is the first country to put in place this Frontclear-designed and structured practical framework within which to develop a more stable and inclusive interbank market among local banks. Tradeclear deepens the interbank market by mitigating credit risk on interbank transactions, introducing best practice GMRA and ISDA documentation, reforming the legal and regulatory framework, and building knowledge and capacity among market participants.
In Uganda, the legal and regulatory review on enforceability of the GMRA and ISDA is in final stages and should be completed soon and a number of banks are now ready to sign up to the Umbrella Guarantee Facility also known as Tradeclear. Today marks the beginning of a formal relationship that we believe should contribute to further transformation of the financial markets landscape in Uganda.
Michael Atingi-Ego, Deputy Governor of the Bank of Uganda
Unprecedented Times
The COVID-19 pandemic and resulting economic crisis pushed governments the world over to increase public debt to unprecedented levels. While this ensured that deeper negative economic consequences were staved off, many developing countries are now left in a precarious position. The fiscal positions of EMDC governments have deteriorated after providing extensive support for two years. The increased local liquidity has masked real risk levels and inadequately reflected in lower credit spreads for countries and counterparties. Banks in EMDC markets have shown caution in terms of extending new loans to the private sector. Rather, financial institutions have shored up their portfolios in government securities, thereby helping local governments to deal with higher deficits (from fiscal support initiatives) and lower collected revenues (from reduced economic activity). The impact of the pandemic on banks’ asset quality will only be known once loan restructuring and debt service grace periods end, when clients are expected to fully perform on their obligations again.
As the pandemic’s impact on different sectors abates and the reduction in economic activity is reversing quickly, the massive liquidity and cost-push impacts of substantial reallocations of labor during COVID-19 are likely to lead to higher inflation. Frontier market central banks must be confident of their monetary policy toolbox when targeting this surge in inflation. Yet most face stubbornly inefficient transmission mechanisms. The existence of perceived and real counterparty credit risk segments the market and all but halts interbank activity and the flow of liquidity among banks. In addition, the absence of a legal and regulatory regime that supports close-out netting is a constraint to market development as it exposes the market participants to undue credit and liquidity risks in repo and derivative transactions.
In these ever-changing market circumstances, local bank access to global capital markets, and deepening domestic capital markets, remains as urgent as ever. Continued market access to diversified sources of domestic and international funding is central to managing heavy debt burdens and ensuring optimal allocation of capital in the economy.
Market Segmentation in Frontier Markets
Under normal market conditions, let alone in a crisis, (perceived) counterparty credit risk quickly dislocates banking relationships. Without access to the interbank system and in particularly repo, banks hoard liquidity as a primary risk mitigator. Larger banks experience lower borrowing costs and often only trade with one another. Smaller players, who often play an outsized role in serving SMEs, are locked-out or have high borrowing costs despite overall liquidity in the market. The financial system’s overall financial soundness and role to effectively extend loans and financial products to the real economy, suffers.
Unprecedented Solution
Banks rely on interbank markets to deal with immediate liquidity concerns and to transmit changes in monetary policy. Interbank lending is where banks borrow and lend to each other using financial instruments such as repurchase agreements (repos) and hedge balance sheet risks through derivatives. Central banks rely on the same interbank market to transmit their monetary policy signals. The segmentation of the interbank market due to counterparty credit risk concerns impairs both these mechanisms. Tradeclear©, an Umbrella Guarantee Facility (UGF), is a systemic approach to reducing a counterparty credit risk for the participants that allows for an inclusive and liquid interbank market, solving the market segmentation and repair monetary policy transmission.
In a Tradeclear all interbank transactions among eligible banks in a country are guaranteed. This mitigates counterparty credit risk and allows liquidity to flow among tiers in the system, while simultaneously building-up operational experience with best practice documentation (GMRA and ISDA) and transaction knowledge (e.g. margining, collateral management). Tradeclear© reflects pre-CCP market infrastructure solution and a secure approach to a more inclusive interbank market.
In a Tradeclear, Frontclear guarantees the payment of early termination and unwind values upon default of a participating bank, mitigating counterparty credit risk and settlement risk. Key expected benefits for the market includes an increased number of trading lines for each participating bank and thus reduced interbank segmentation between the different bank tiers. This should lead to improved pricing, reduced reliance on central bank facilities, improved market resilience to shocks, improved secondary bond market liquidity, development of an interest rate benchmark and yield curve and improved monetary policy transmission. Participating banks receive ongoing capacity-building support through the Frontclear Academy and gain access to the Tradeclear guarantee platform which provides valuation and collateral management capabilities to banks who have not yet developed these systems internally.
UNECA / Frontclear Partnership
The United Nations Economic Commission for Africa (UNECA) and Stichting FTAP (Frontclear Technical Assistance Programme, a Foundation) have formed a partnership to support African countries to address the adverse effects of the pandemic on national debt and financial markets. The direct purpose is to strengthen their local financial institutions, financial system and investor base (both domestic and international), which will not only help governments mobilize more funding for economic recovery and building back better, but also help build financial resilience towards future shocks. One of the activities supported by the partnership is the Tradeclear© Feasibility Study. Central Banks from African markets such as the Bank of Zambia, have signed the request to work with the local market and the partnership, to develop a Tradeclear© structure customized to their market, idiosyncratic features. The Zambia effort was kicked-off in a Lusaka workshop in late May 2022. The Study will consider local demand dynamics, legal & regulatory framework, clearing and settlement system and market knowledge, with a proposed model by close 2022.
An Invitation
Deep and efficient domestic government debt markets help provide resilience to shocks in times of financial turbulence and convey multiple economic benefits. These markets mitigate currency pressures and are central to broader capital market development, facilitating appropriate pricing of risk, allowing participants in financial markets to better manage their portfolios. In turn, these factors help boost a country’s long-term economic growth potential and ability to weather external shocks.
A participatory and liquid interbank market is key to the development of local currency government debt markets. Frontclear, through programmes like Tradeclear, continually strives to support local governments and banking sector counterparties, to develop their interbank and money market. The International Capital Market Association (ICMA) is a long-standing partner in this effort, combining with Frontclear to review and reform legal and regulatory frameworks in frontier markets. We welcome all ICMA members to join in these efforts to the benefit of global market stability and resilient financial markets (Sustainable Development Goals 8 ad 17).
About Frontclear
Frontclear is an Amsterdam based development finance institution. Frontclear is funded by European development finance institutions, including the European Bank for Reconstruction and Development (EBRD), the Dutch development bank FMO, the Financial Sector Deepening Africa (FSDA), the French development bank Proparco, The Currency Exchange Fund (TCX), the UK’s Foreign, Commonwealth and Development Office (FCDO) and the German Ministry of Development Cooperation (BMZ). Frontclear’s guarantees are counter-guaranteed by KfW, a AAA-rated German development Bank. Frontclear’s development mandate is focused on catalyzing more stable and inclusive financial markets in emerging and frontier markets through the provision of financial guarantees to cover counterparty credit risk. Frontclear also offers technical assistance to develop the financial infrastructure, legal environment as well as the skills and capacity of the local market participants.
