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©2011-2012 International Swaps and Derivatives Association, Inc. ISDA ® is a registered trademark of the International Swaps and Derivatives Association,

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Presentation on theme: "©2011-2012 International Swaps and Derivatives Association, Inc. ISDA ® is a registered trademark of the International Swaps and Derivatives Association,"— Presentation transcript:

1 © International Swaps and Derivatives Association, Inc. ISDA ® is a registered trademark of the International Swaps and Derivatives Association, Inc. A Short Introduction to the Standard Credit Support Annex Michael Clarke Managing Director Goldman, Sachs & Co.

2 $2.9 trillion collateral in circulation for derivatives >150,000 agreements Many examples of effective loss mitigation during credit events since 1996 Collateral in circulation Source : ISDA Margin Survey 2011 and earlier years Volume of Collateral in US$ billions (Bars) Collateral Agreements (Line) 2 15

3 The CSA permits: Delivering Party choice of collateral asset from the list of Eligible Collateral Delivering Party ability to substitute collateral Receiving Party consent for substitutions under English Law CSAs (to reduce re-characterization risk) These are options and have economic value. How can we project their future value? How can they be priced? Extreme pricing complexity Impossible to hedge The CSA is the most exotic of exotic derivatives Issue 1 - Embedded optionality 3 20

4 The CSA takes the mark-to-market exposure of many transactions in different currencies, nets them, and requires collateral to cover that amount (ignoring Thresholds, MTAs and IA). In most cases, the collateral is delivered in a single currency, often USD or EUR. Interest accrues at the overnight index rate for the relevant currency of the collateral actually delivered, e.g. Fed Funds or EONIA. This creates a mismatch in funding currency and interest accrual between the underlying derivative cashflows and the collateral. Issue 2 - Embedded funding mismatch 4 21

5 Consider a swap with a single cashflow of $10 in one year... Aligning collateral and swap cashflows 5 Under the SCSA collateral is required to cover the mark-to-market value of the swap, so $9 of collateral is delivered today. Under the SCSA collateral must be cash in the currency of the swap, and cash collateral earns interest at the OIS rate. Therefore $9 of collateral delivered today earns interest of $1 over the next year. When it is returned at the end of the swap, the collateral plus interest will precisely cover the $10 cashflow due - with no currency risk and no basis risk. If properly aligned, the collateral funds the future swap cashflow. Time FV = $10 PV = $9 Discount rate i = OIS Today+ 1 Year PV = (1+ i ) n FV 22

6 1. Accruals by Currency Silo Undisputed Amount (in currency) Spot FX Rate Net Undisputed Amount (in Transport Currency) Collateral Actually Delivered under CSA Implied Funding Rate Index Implied Funding Rate Implied Annual Funding Cost USD Equivalent for Comparison USD 8,000, ,000,000 n/a Fed Funds H % USD 6,400USD 6,400 EUR 100,000, ,102,400 n/a EONIA % EUR 1,071,000USD 1,543,337 JPY (5,000,000) (50,000) n/a Mutan Call % JPY (28,005)USD (280) GBP (6,000,000) (9,660,000) n/a SONIA % GBP (5,700)USD (9,177) CHF (2,000,000) (2,320,000) n/a TOIS % CHF (420)USD (487) Total: 140,072,400 Total:USD 1,549, Accrual for Transport Currency If Held Unconverted Net Undisputed Amount (in Transport Currency) Collateral Actually Delivered under CSA Actual Funding Rate Index if Held in Transport Currency Actual Funding Rate Actual Annual Funding Cost USD Equivalent for Comparison Portfolio 140,072,400 Fed Funds H %USD 112,058USD 112,058 Example: Economics of mis-alignment 6 × 23

7 There is an active market in derivative novation and assignment. In addition, regulators and market participants are encouraging the transfer of bilateral risk to CCPs where possible. The LIBOR-OIS discounting issue discussed earlier makes these risk transfers more difficult, because of the differences in choice of underlying curve. The collateral-related effects render these risk transfers even more difficult, since CSA terms are not consistent across the market, and the two parties to a given CSA may factor the collateral terms into pricing differently (if at all). Issue 3 - Impediments to risk transfer 7 24

8 The inherent flexibility of the CSA is a major positive in that the vast majority of the exceedingly wide universe of derivatives executed with the entire spectrum of credit quality counterparties can be collateralized under a CSA. However, regulatory perception is that not all variations under the CSA are warranted; or put another way, standardizing some terms to reduce the number of variations would not harm the market. Focus on eligible collateral, Thresholds, MTAs and IA. Operational procedures and market standards are in fact very consistent across market participants. Issue 4 - Lack of standardization 8 25

9 How the SCSA works: Context PARTY X PARTY Y Portfolio of executed transactions between two counterparties Transactions clearable when executed Transactions not clearable when executed Clearing House 1 Clearing House 2 Clearing House 3 Clearing House 4 Clearing House 5 Clearing House …n… Each clearing house has its own unique margin rules CSA (Legacy Trades ) SCSA (New trades) One net collateral requirement each day, delivered in eligible collateral of choice One collateral requirement per currency each day, delivered in each currency or converted to a single currency with an interest adjustment overlay. Netting Set maintained across full Master Agreement scope and all collateral. Trades may be moved from the CSA to the SCSA (but not vice versa). See over for detailed mechanics 9 28

10 How the SCSA works: Mechanics Designated Collateral Currency (DCC) Silos PARTY XPARTY Y PARTY X PERSPECTIVE: PARTY X EUR TransactionsGBP TransactionsCHF TransactionsJPY Transactions EURGBPCHFJPY All Transactions Pro Forma Current CSA for Comparison INCLUDED TRANSACTIONS (See next page for cross-currency transactions and non-G5 single currency transactions) USD EXPOSURE MTM USD MTM EUR MTM GBP MTM CHF MTM JPY COLLATERAL CASH USD CASH EUR CASH GBP CASH CHF CASH JPY REQUIRED SETTLEMENT Threshold = 0 MTA = 0 CASH USD CASH EUR CASH GBP CASH CHF CASH JPY MTM ALL CASH ALL + SECURITIES ALL MTM USD MTM EUR MTM GBP MTM CHF MTM JPY MTM ALL CASH ALL + SECURITIES ALL - OR SAFE SETTLEMENT (PVP OR ESCROW) PLATFORM OR COMMON ARBITRAGE-FREE IMPLIED SWAP ADJUSTMENT MODEL OR PARTY Y MIRROR IMAGE PARTY Y PERSPECTIVE Herstatt Risk Elimination THRESHOLD - 10 USD Transactions OR 29

11 Silo (DCC) and Transport (CSC) Currencies 11 Designated Collateral Currencies (Silos) Convert to a Collateral Settlement Currency (Transport Currency) and Net Settle the Net Transport Currency Amount Re-convert to Silo currencies USDEURJPYGBPCHF..etc..G17 Compute and pay interest at OIS on Silo balances of collateral 5 USDEURJPYGBPCHF..etc..G17 Required by the SCSA + ISA Required by the SCSA + ISA Determined by firm- specific ALM considerations, not the SCSA 49

12 Receiving party has a choice There is no SCSA requirement for the party receiving the net amount of Transport currency to do anything in particular with it…. BUT… it is fully rehypothecable and each party has the obligation to pay interest at OIS for each silo Undisputed Amount Which implies two important actions for the parties… 12 PARTY XPARTY Y USD 140,072,400 Collateral Amount Physically Moved PARTY XPARTY Y Interest Obligations EUR 1,071,000 JPY (28,005) GBP (5,700) CHF (420) USD 6,400 51

13 Balances must be manufactured The actual physical movement was USD 140,072,400. The implied DCC silo balances were however… So Party X has to establish balances of EUR 100mm and USD 8mm on which to accrue interest it will pay. This is more than the physical movement received. Party Y has to do the same for JPY 5mm, CHF 2mm and GBP 6mm. This is more than the physical movement received (which was nothing, because Y delivered to X of course). 13 PARTY XPARTY Y Implied Silo Balances EUR 100mm JPY 5mm GBP 6mm CHF 2mm USD 8mm 52

14 Integration into treasury management Balance sheet obligations for the individual DCC balances need to be established, so that correct accruals can occur. The actual physical movement of USD 140,072,400 also needs to be addressed. It needs to be funded by Party Y and invested by Party X. It must therefore be integrated into the treasury management processes at the two firms. The receiver of the physical movement will need to consider: Converting the received transport currency amount into the relevant DCC silo balances - a direct hedge of the funding risk. Factor the received transport currency amount into the general treasury funding flows for the day - a portfolio hedge of the funding risk. Leave the collateral in the transport currency and do not hedge. We do not recommend the last option

15 Baseline funding and collateral flows 15 PARTY XPARTY Y 1 9 EUR 100mm EONIA 6 8 EUR 100mm 2 EONIA 5 Collateral Flows Party Y Funding Trade 3 7 EUR 100mm EONIA 4 Party X Funding Trade Net InterestZero 54

16 Netted settlement collateral flows (EUR silo only) 16 PARTY XPARTY Y 1 13 USD 144,102,400 Fed Funds USD 144,100,000 2 USD 144,102,400 EONIA 3 USD 144,102,400 4 EUR 100,000,000 USD 144,100,000 EUR 100,000, EONIA Collateral Flows Party Y Funding Trade Tom/Next Swap Party X Funding Trade Basis Difference Cash Difference 55

17 Receive EONIA 3,635 Pay Fed Funds (1,001) Cash Difference (2,400) Net234 (Cross-currency basis) Economics 17 PARTY XPARTY Y Receive EONIA 3,635 Pay EONIA(3,635) Net Zero 56

18 Cross Currency Basis 18 Cross-currency basis refers to the spread adjustment required on one leg of a Libor vs. floating cross-currency swap in order to make the swap price at par. This basis is observable in the market (see Bloomberg or Reuters swap rate screens). There is a no-arbitrage relation between FX forwards, interest rate swap levels, and cross- currency basis. Two streams of par cashflows in different currencies may have a zero present value when considered each in isolation, but when linked via a transaction the net value is non-zero; the difference is the cross-currency basis and reflects the differences in perceived credit risk and market access between the parties funding in the two currencies. Cross-currency basis may be positive or negative. The ISA methodology implicitly includes the cross-currency bases for all silos. One can consider the $234 cross-currency basis as the cost of using net settlement (the ISA methodology) to eliminate Herstatt risk and compare it to the cost of constructing alternative methods of managing this risk (eg building a PVP platform). 57

19 SCSA program plan 19 Q4 2011Q1 2012Q2 2012Q3 2012Q4 2012Q Phase 1 Live Date August 10 PVP Requirement Definition PVP Infra Construction and Testing FPML Design Phase 1 - Pathfinder Implementation for Volunteer Firms (Timings are highly uncertain) Phase 2 - Wider Market Adoption Timing for PVP delivery is highly uncertain at this time and dependent on third party construction. Historical examples of linked-settlement infrastructure have shown that construction can take many years. Counsel Review 1. Commercial Design Stream 2. Legal Stream 3. FPML Stream 4.Infrastructure Stream 6.Execution Stream Adoption Design Execution Test Prep Continued Business Technical Input Local Counsel Opinion Updates JANFEBMARAPRMAYJUNJULAUGSEPOCTNOVDEC Arrows illustrate certain key dependencies NOW 7. Education and Regulatory Outreach Stream Market Education Regulatory Outreach Market Education 5.ISDA SCSAFIX Stream Design Market Testing Design Infra Spec Legal Doc Drafting Commercial Design Program critical path is outlined in blue Internal IT Change ISDAFix SCSA Build Market Infra Development ISA Details As of February 28, subject to change Market Education Bilateral pairs of firms may execute the SCSA at any time after August 10 60

20 Removes collateral switch options Restricts variation margin to cash only, so that collateral interest accruals will approximate the funding cost of the underlying cashflows. Further limits this to cash for which a liquid OIS market exists. Will be extensible as other OIS markets develop liquidity, promoting the growth of liquid OIS markets. Simplifies calculations by standardizing terms. Eliminates structural CSA differences, thus: Trade valuation more consistent and transparent. Making novation, assignment and risk transfer to CCPs easier. Reducing one cause of margin disputes. Advantages of the SCSA 20 61


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