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 - PowerPoint PPT Presentation
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• 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.
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Aligning collateral and swap cashflowsAligning collateral and swap cashflows
• Consider a swap with a single cashflow of $10 in one year...
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• 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
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Example: Economics of mis-alignmentExample: Economics of mis-alignment
Issue 3 - Impediments to risk transferIssue 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).
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Issue 4 - Lack of standardizationIssue 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.
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How the SCSA works: ContextHow the SCSA works: Context
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PARTY X PARTY Y
Portfolio of executed transactions between two counterparties
Transactions clearable when executed
Transactions not clearable when executed
Clearing House1
Clearing House2
Clearing House3
Clearing House4
Clearing House5
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
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How the SCSA works: MechanicsHow the SCSA works: Mechanics
• 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).
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SCSA program planSCSA program plan As of February 28, 2012 - subject to change
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Q4 2011 Q1 2012 Q2 2012 Q3 2012 Q4 2012 Q1 2013
Phase 1Live Date August 10
PVP Requirement Definition
PVP InfraConstruction and Testing
FPML Design
Phase 1 - Pathfinder Implementation for Volunteer Firms
(Timings are highly uncertain)Phase 2 - Wider Market AdoptionTiming 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. InfrastructureStream
6. ExecutionStream Adoption
DesignExecution
Test Prep
Continued Business Technical Input
Local Counsel Opinion Updates
JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV DEC
Arrows illustrate certain key dependencies
NOW
7. Education and Regulatory Outreach Stream
MarketEducation
Regulatory Outreach
MarketEducation
5. ISDA SCSAFIXStream
Design
MarketTesting
Design
Infra Spec
Legal Doc Drafting
CommercialDesign
Program critical path is outlined in blue
InternalIT Change
ISDAFix SCSA Build
Market Infra Development
ISA Details
MarketEducation
Bilateral pairs of firms may execute the SCSA at any
time after August 10
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Advantages of the SCSAAdvantages 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.