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A Short Introduction to the Standard Credit Support Annex

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1 A Short Introduction to the Standard Credit Support Annex
Michael Clarke Managing Director Goldman, Sachs & Co.

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

3 Issue 1 - Embedded optionality
20 Issue Embedded optionality 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”

4 Issue 2 - Embedded funding mismatch
21 Issue Embedded funding mismatch 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.

5 Aligning collateral and swap cashflows
22 Aligning collateral and swap cashflows Consider a swap with a single cashflow of $10 in one year... Time FV = $10 PV = $9 Discount rate i = OIS Today + 1 Year PV = (1+i)n FV 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.

6 Example: Economics of mis-alignment
23 Example: Economics of mis-alignment 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 n/a Fed Funds H-15 0.0800% 6,400 EUR 100,000,000 144,102,400 EONIA 1.0710% 1,071,000 1,543,337 JPY (5,000,000) (50,000) Mutan Call 0.5601% (28,005) (280) GBP (6,000,000) (9,660,000) SONIA 0.0950% (5,700) (9,177) CHF (2,000,000) (2,320,000) TOIS 0.0210% (420) (487) Total: 140,072,400 1,549,737 2. Accrual for Transport Currency If Held Unconverted Actual Funding Rate Index if Held in Transport Currency Actual Funding Rate Actual Annual Funding Cost Portfolio 0.08% 112,058 ×

7 Issue 3 - Impediments to risk transfer
24 Issue Impediments to risk transfer 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).

8 Issue 4 - Lack of standardization
25 Issue Lack of standardization 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.

9 How the SCSA works: Context
28 How the SCSA works: Context Portfolio of executed transactions between two counterparties PARTY X PARTY Y Transactions clearable when executed Transactions not clearable when executed Clearing House 1 Clearing House 2 CSA (Legacy Trades) SCSA (New trades) See over for detailed mechanics Clearing House 3 Clearing House 4 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. Clearing House 5 Clearing House …n… Each clearing house has its own unique margin rules 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).

10 How the SCSA works: Mechanics

11 Silo (DCC) and Transport (CSC) Currencies
49 Silo (DCC) and Transport (CSC) Currencies 1 Designated Collateral Currencies (“Silos”) USD EUR JPY GBP CHF ..etc.. G17 Required by the SCSA + ISA 2 Convert to a Collateral Settlement Currency (“Transport Currency”) and Net Settle the Net Transport Currency Amount 3 Re-convert to Silo currencies 4 Determined by firm-specific ALM considerations, not the SCSA USD EUR JPY GBP CHF ..etc.. G17 Required by the SCSA + ISA Compute and pay interest at OIS on Silo balances of collateral 5

12 Receiving party has a choice
51 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… Collateral Amount Physically Moved PARTY X USD 140,072,400 PARTY Y Interest Obligations JPY (28,005) CHF (420) PARTY X EUR 1,071,000 PARTY Y GBP (5,700) USD 6,400

13 Balances must be manufactured
52 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). Implied Silo Balances EUR 100mm JPY 5mm GBP 6mm CHF 2mm USD 8mm PARTY X PARTY Y

14 Integration into treasury management
53 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
54 Baseline funding and collateral flows Collateral Flows PARTY X PARTY Y EUR 100mm EUR 100mm EUR 100mm 3 2 1 EONIA Party X Funding Trade EONIA EONIA 7 8 9 Party Y Funding Trade EUR 100mm EUR 100mm EUR 100mm 4 5 6 Net Interest Zero Net Interest Zero

16 Netted settlement collateral flows (EUR silo only)
55 Netted settlement collateral flows (EUR silo only) Collateral Flows PARTY X PARTY Y USD 144,102,400 USD 144,102,400 USD 144,102,400 3 2 1 4 EUR 100,000,000 Fed Funds Tom/Next Swap EONIA Basis Difference 12 13 Party Y Funding Trade EUR 100,000,000 7 USD 144,100,000 Cash Difference USD 144,102,400 8 9 10 USD 144,100,000 5 EONIA EUR 100,000,000 EUR 100,000,000 11 6 Party X Funding Trade

17 Economics PARTY X PARTY Y 56 Receive EONIA 3,635 Pay EONIA (3,635)
Net Zero Receive EONIA 3,635 Pay Fed Funds (1,001) Cash Difference (2,400) Net 234 (Cross-currency basis)

18 57 Cross Currency Basis 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).

19 SCSA program plan 60 Q4 2011 Q1 2012 Q2 2012 Q3 2012 Q4 2012 Q1 2013
As of February 28, subject to change Q4 2011 Q1 2012 Q2 2012 Q3 2012 Q4 2012 Q1 2013 Phase Pathfinder Implementation for Volunteer Firms JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV DEC 1. Commercial Design Stream Commercial Design Continued Business Technical Input Arrows illustrate certain key dependencies 2. Legal Stream Legal Doc Drafting Counsel Review Local Counsel Opinion Updates Program critical path is outlined in blue 3. FPML Stream FPML Design Infra Spec Market Infra Development 4. Infrastructure Stream Design Internal IT Change 5. ISDA SCSAFIX Stream ISA Details Design ISDAFix SCSA Build Test Prep Market Testing Phase 1 Live Date August 10 6. Execution Stream Bilateral pairs of firms may execute the SCSA at any time after August 10 Adoption Design Execution Market Education Market Education Market Education 7. Education and Regulatory Outreach Stream Regulatory Outreach Phase 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 Definition PVP Infra Construction and Testing NOW

20 Advantages of the SCSA Removes collateral “switch options”
61 Advantages of the SCSA 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.

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