A short introduction to the standard credit support annex
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A Short Introduction to the Standard Credit Support Annex. Michael Clarke Managing Director Goldman, Sachs & Co. 15. Collateral in circulation. $2.9 trillion collateral in circulation for derivatives >150,000 agreements

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A Short Introduction to the Standard Credit Support Annex

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A short introduction to the standard credit support annex

A Short Introduction to theStandard Credit Support Annex

Michael ClarkeManaging DirectorGoldman, Sachs & Co.


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


Issue 1 embedded optionality

20

Issue 1 - 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”


Issue 2 embedded funding mismatch

21

Issue 2 - 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.


Aligning collateral and swap cashflows

22

Aligning collateral and swap cashflows

Consider a swap with a single cashflow of $10 in one year...

Discount rate i = OIS

FV = $10

FV

PV =

PV = $9

(1+i)n

Time

Today

+ 1 Year

  • 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.


Example economics of mis alignment

23

Example: Economics of mis-alignment

×


Issue 3 impediments to risk transfer

24

Issue 3 - 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).


Issue 4 lack of standardization

25

Issue 4 - 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.


How the scsa works context

28

How the SCSA works: Context

Portfolio of executed transactions between two counterparties

PARTY Y

PARTY X

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).


How the scsa works mechanics

29

OR

OR

OR

OR

OR

OR

OR

OR

OR

OR

How the SCSA works: Mechanics

PARTY X

PARTY Y

PARTY X PERSPECTIVE:

Designated Collateral Currency (DCC) Silos

Pro Forma

Current CSA for Comparison

PARTY X

USD

EUR

GBP

CHF

JPY

USD Transactions

EUR Transactions

GBP Transactions

CHF Transactions

JPY Transactions

All Transactions

INCLUDED

TRANSACTIONS

(See next page for cross-currency transactions and non-G5 single currency transactions)

∑MTMUSD

∑MTMEUR

∑MTMALL

∑MTMGBP

∑MTMCHF

∑MTMJPY

EXPOSURE

∑CASHALL +

∑CASHUSD

∑CASHEUR

∑CASHGBP

∑CASHCHF

∑CASHJPY

∑SECURITIESALL

COLLATERAL

∑CASHALL +

∑CASHUSD

-

∑CASHEUR

-

∑CASHGBP

-

∑CASHCHF

-

∑CASHJPY

-

REQUIRED

SETTLEMENT

Threshold = 0

MTA = 0

-

∑SECURITIESALL

∑MTMALL

-

∑MTMUSD

∑MTMEUR

∑MTMGBP

∑MTMCHF

∑MTMJPY

THRESHOLD

Herstatt Risk Elimination

SAFE SETTLEMENT (PVP OR ESCROW) PLATFORM

OR COMMON ARBITRAGE-FREE IMPLIED SWAP ADJUSTMENT MODEL

OR

PARTY Y

MIRROR IMAGE PARTY Y PERSPECTIVE


Silo dcc and transport csc currencies

49

Silo (DCC) and Transport (CSC) Currencies

Designated Collateral Currencies (“Silos”)

1

USD

EUR

JPY

GBP

CHF

..etc..

G17

Required by

the SCSA + ISA

Convert to a Collateral Settlement Currency

(“Transport Currency”) and Net

2

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


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

PARTY Y

USD 140,072,400

Interest Obligations

JPY (28,005)

CHF (420)

PARTY X

PARTY Y

EUR 1,071,000

GBP (5,700)

USD 6,400


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

PARTY X

PARTY Y

JPY 5mm

CHF 2mm

EUR 100mm

GBP 6mm

USD 8mm


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.


Baseline funding and collateral flows

54

Baseline funding and collateral flows

Collateral Flows

PARTY X

PARTY Y

EUR 100mm

EUR 100mm

EUR 100mm

1

2

3

EONIA

EONIA

EONIA

Party Y Funding Trade

Party X Funding Trade

9

7

8

EUR 100mm

EUR 100mm

EUR 100mm

5

6

4

Net InterestZero

Net InterestZero


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

1

3

2

4

EUR 100,000,000

Fed Funds

EONIA

Basis Difference

Party Y Funding Trade

Tom/Next Swap

13

12

EUR 100,000,000

7

USD 144,102,400

Cash Difference

USD 144,100,000

9

10

8

USD 144,100,000

5

EUR 100,000,000

EUR 100,000,000

EONIA

6

11

Party X Funding Trade


Economics

56

Economics

PARTY X

PARTY Y

Receive EONIA 3,635

Pay EONIA(3,635)

Net Zero

Receive EONIA 3,635

Pay Fed Funds (1,001)

Cash Difference (2,400)

Net234

(Cross-currency basis)


Cross currency basis

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).


Scsa program plan

60

SCSA program plan

As of February 28, 2012 - subject to change

Q4 2011

Q1 2012

Q2 2012

Q3 2012

Q4 2012

Q1 2013

Phase 1 - Pathfinder Implementation for Volunteer Firms

JAN

FEB

MAR

APR

MAY

JUN

JUL

AUG

SEP

OCT

NOV

DEC

Arrows illustrate certain key dependencies

1. Commercial Design Stream

Commercial

Design

Continued Business Technical Input

Program critical path is outlined in blue

Legal Doc Drafting

Counsel Review

Local Counsel Opinion Updates

2. Legal Stream

FPML Design

3. FPML Stream

Infra Spec

Market Infra Development

4.Infrastructure

Stream

Internal

IT Change

Design

5.ISDA SCSAFIX

Stream

ISA Details

Design

ISDAFix SCSA Build

Phase 1

Live Date August 10

Test Prep

Market

Testing

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 2 - 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


Advantages of the scsa

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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