Presentation on theme: "A Short Introduction to the Standard Credit Support Annex"— Presentation transcript:
1 A Short Introduction to the Standard Credit Support Annex Michael Clarke Managing Director Goldman, Sachs & Co.
2 Collateral in circulation 15Collateral in circulation$2.9 trillion collateral in circulation for derivatives>150,000 agreementsMany examples of effective loss mitigation during credit events since 1996Volume of Collateral in US$ billions(Bars)Collateral Agreements (Line)Source : ISDA Margin Survey 2011 and earlier years
3 Issue 1 - Embedded optionality 20Issue Embedded optionalityThe CSA permits:Delivering Party choice of collateral asset from the list of Eligible CollateralDelivering Party ability to substitute collateralReceiving 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 complexityImpossible to hedge“The CSA is the most exotic of exotic derivatives”
4 Issue 2 - Embedded funding mismatch 21Issue Embedded funding mismatchThe 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.
5 Aligning collateral and swap cashflows 22Aligning collateral and swap cashflowsConsider a swap with a single cashflow of $10 in one year...TimeFV = $10PV = $9Discount rate i = OISToday+ 1 YearPV =(1+i)nFVUnder 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.
6 Example: Economics of mis-alignment 23Example: Economics of mis-alignment1. Accruals by Currency SiloUndisputed Amount (in currency)Spot FX RateNet Undisputed Amount (in Transport Currency)Collateral Actually Delivered under CSAImplied Funding Rate IndexImplied Funding RateImplied Annual Funding CostUSD Equivalent for ComparisonUSD8,000,000n/aFed Funds H-150.0800%6,400EUR100,000,000144,102,400EONIA1.0710%1,071,0001,543,337JPY(5,000,000)(50,000)Mutan Call0.5601%(28,005)(280)GBP(6,000,000)(9,660,000)SONIA0.0950%(5,700)(9,177)CHF(2,000,000)(2,320,000)TOIS0.0210%(420)(487)Total:140,072,4001,549,7372. Accrual for Transport Currency If Held UnconvertedActual Funding Rate Index if Held in Transport CurrencyActual Funding RateActual Annual Funding CostPortfolio0.08%112,058×
7 Issue 3 - Impediments to risk transfer 24Issue Impediments to risk transferThere 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).
8 Issue 4 - Lack of standardization 25Issue Lack of standardizationThe 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.
9 How the SCSA works: Context 28How the SCSA works: ContextPortfolio of executed transactions between two counterpartiesPARTY XPARTY YTransactions clearable when executedTransactions not clearable when executedClearing House1Clearing House2CSA(Legacy Trades)SCSA(New trades)See over for detailed mechanicsClearing House3Clearing House4One net collateral requirement each day, delivered in eligible collateral of choiceOne collateral requirement per currency each day, delivered in each currency or converted to a single currency with an interest adjustment overlay.Clearing House5Clearing House…n…Each clearing house has its own unique margin rulesNetting Set maintained across full Master Agreement scope and all collateral.Trades may be moved from the CSA to the SCSA (but not vice versa).
10 How the SCSA works: Mechanics 29How the SCSA works: MechanicsPARTY XPARTY YPARTY X PERSPECTIVE:Designated Collateral Currency (DCC) SilosPro FormaCurrent CSA for ComparisonPARTY XUSDEURGBPCHFJPYUSD TransactionsEUR TransactionsGBP TransactionsCHF TransactionsJPY TransactionsAll TransactionsINCLUDEDTRANSACTIONS(See next page for cross-currency transactions and non-G5 single currency transactions)∑MTMUSD∑MTMEUR∑MTMGBP∑MTMCHF∑MTMJPY∑MTMALLEXPOSURE∑CASHALL +∑CASHUSD∑CASHEUR∑CASHGBP∑CASHCHF∑CASHJPYCOLLATERAL∑SECURITIESALL∑CASHALL +REQUIREDSETTLEMENTThreshold = 0MTA = 0∑CASHUSD-∑CASHEUR-∑CASHGBP-∑CASHCHF-∑CASHJPY-∑SECURITIESALL-∑MTMUSD∑MTMEUR∑MTMGBP∑MTMCHF∑MTMJPY∑MTMALL-THRESHOLDORORORORORHerstatt Risk EliminationSAFE SETTLEMENT (PVP OR ESCROW) PLATFORMOR COMMON ARBITRAGE-FREE IMPLIED SWAP ADJUSTMENT MODELORORORORORORPARTY YMIRROR IMAGE PARTY Y PERSPECTIVE
11 Silo (DCC) and Transport (CSC) Currencies 49Silo (DCC) and Transport (CSC) Currencies1Designated Collateral Currencies (“Silos”)USDEURJPYGBPCHF..etc..G17Required bythe SCSA + ISA2Convert to a Collateral Settlement Currency(“Transport Currency”) and NetSettle the Net Transport Currency Amount3Re-convert to Silo currencies4Determined by firm-specific ALM considerations, not the SCSAUSDEURJPYGBPCHF..etc..G17Required bythe SCSA + ISACompute and pay interest at OIS on Silo balances of collateral5
12 Receiving party has a choice 51Receiving party has a choiceThere 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 AmountWhich implies two important actions for the parties…Collateral Amount Physically MovedPARTY XUSD 140,072,400PARTY YInterest ObligationsJPY (28,005)CHF (420)PARTY XEUR 1,071,000PARTY YGBP (5,700)USD 6,400
13 Balances must be manufactured 52Balances must be manufacturedThe 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).Implied Silo BalancesEUR 100mmJPY 5mmGBP 6mmCHF 2mmUSD 8mmPARTY XPARTY Y
14 Integration into treasury management 53Integration into treasury managementBalance 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 54Baseline funding and collateral flowsCollateral FlowsPARTY XPARTY YEUR 100mmEUR 100mmEUR 100mm321EONIAParty X Funding TradeEONIAEONIA789Party Y Funding TradeEUR 100mmEUR 100mmEUR 100mm456Net Interest ZeroNet Interest Zero
17 Economics PARTY X PARTY Y 56 Receive EONIA 3,635 Pay EONIA (3,635) Net ZeroReceive EONIA 3,635Pay Fed Funds (1,001)Cash Difference (2,400)Net 234(Cross-currency basis)
18 57Cross Currency BasisCross-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).
19 SCSA program plan 60 Q4 2011 Q1 2012 Q2 2012 Q3 2012 Q4 2012 Q1 2013 As of February 28, subject to changeQ4 2011Q1 2012Q2 2012Q3 2012Q4 2012Q1 2013Phase Pathfinder Implementation for Volunteer FirmsJANFEBMARAPRMAYJUNJULAUGSEPOCTNOVDEC1. Commercial Design StreamCommercialDesignContinued Business Technical InputArrows illustrate certain key dependencies2. Legal StreamLegal Doc DraftingCounsel ReviewLocal Counsel Opinion UpdatesProgram critical path is outlined in blue3. FPML StreamFPML DesignInfra SpecMarket Infra Development4. InfrastructureStreamDesignInternalIT Change5. ISDA SCSAFIXStreamISA DetailsDesignISDAFix SCSA BuildTest PrepMarketTestingPhase 1Live Date August 106. ExecutionStreamBilateral pairs of firms may execute the SCSA at any time after August 10Adoption DesignExecutionMarketEducationMarketEducationMarketEducation7. Education and Regulatory Outreach StreamRegulatory OutreachPhase Wider Market Adoption(Timings are highly uncertain)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.PVP Requirement DefinitionPVP InfraConstruction and TestingNOW
20 Advantages of the SCSA Removes collateral “switch options” 61Advantages of the SCSARemoves 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.