A Short Introduction to the
Standard Credit Support Annex
Michael Clarke
Managing Director
Goldman, Sachs & Co.
©2011-2012 International Swaps and Derivatives Association, Inc.
ISDA® is a registered trademark of the International Swaps and Derivatives Association, Inc.
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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)
2
Source : ISDA Margin Survey 2011 and earlier years
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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”
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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.
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22
Aligning collateral and swap cashflows
• Consider a swap with a single cashflow of $10 in one year...
Discount rate i = OIS
FV
PV =
FV = $10
PV = $9
(1+i)n
Today
+ 1 Year
Time
• 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.
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23
Example: Economics of mis-alignment
1. Accruals by Currency Silo
Undisputed
Amount
Spot FX Rate
(in currency)
USD
8,000,000
Net Undisputed
Amount
(in Transport Currency)
1.00000
8,000,000
Collateral Actually
Delivered under
CSA
Implied Funding
Rate Index
n/a
Fed Funds H-15
Implied
Funding
Rate
Implied Annual
Funding Cost
USD Equivalent for
Comparison
USD
6,400
USD
6,400
0.0800%
EUR
100,000,000
1.44102
144,102,400
n/a
EONIA
1.0710%
EUR
1,071,000
USD
1,543,337
JPY
(5,000,000)
0.01000
(50,000)
n/a
Mutan Call
0.5601%
JPY
(28,005)
USD
(280)
GBP
(6,000,000)
1.61000
(9,660,000)
n/a
SONIA
0.0950%
GBP
(5,700)
USD
(9,177)
CHF
(2,000,000)
1.16000
(2,320,000)
n/a
TOIS
0.0210%
CHF
(420)
USD
(487)
Total: USD
1,549,737
Total:
140,072,400
2. Accrual for Transport Currency If Held Unconverted
Net Undisputed
Amount
(in Transport Currency)
Portfolio
140,072,400
Actual Funding
Collateral Actually
Rate Index if Held
Delivered under
in Transport
CSA
Currency
140,072,400
Fed Funds H-15
Actual
Funding
Rate
0.08%
Actual Annual
Funding Cost
USD
112,058

USD Equivalent for
Comparison
USD
112,058
×
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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).
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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.
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28
How the SCSA works: Context
Portfolio of executed transactions between two counterparties
PARTY X
Transactions 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
PARTY Y
Transactions not
clearable when executed
CSA
SCSA
(Legacy Trades)
(New trades)
One net
collateral
requirement
each day,
delivered in
eligible
collateral of
choice
See over for detailed mechanics
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).
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29
How the SCSA works: Mechanics
PARTY X
PARTY Y
PARTY X PERSPECTIVE:
PARTY X
USD
EUR
USD Transactions
INCLUDED
TRANSACTIONS
Designated Collateral Currency (DCC) Silos
EUR Transactions
GBP
CHF
GBP Transactions
CHF Transactions
Pro Forma
Current CSA for
Comparison
JPY
JPY Transactions
All Transactions
(See next page for cross-currency transactions and non-G5 single currency transactions)
EXPOSURE
∑MTM
COLLATERAL
∑CASH
USD
USD
∑MTM
EUR
∑CASH
EUR
∑MTM
GBP
∑CASH
GBP
∑MTM
CHF
∑CASH
CHF
∑MTM
JPY
∑CASH
JPY
∑MTM
∑CASH +
∑SECURITIES
∑CASH +
∑SECURITIES ∑MTM ALL
ALL
ALL
REQUIRED
SETTLEMENT
Threshold = 0
MTA = 0
∑CASH ∑MTM
USD
USD
∑CASH ∑MTM
EUR
EUR
∑CASH ∑MTM
GBP
GBP
∑CASH ∑MTM
CHF
CHF
∑CASH ∑MTM
JPY
JPY
ALL
ALL
ALL
THRESHOLD
OR
Herstatt
Risk
Elimination
OR
OR
OR
OR
SAFE SETTLEMENT (PVP OR ESCROW) PLATFORM
OR COMMON ARBITRAGE-FREE IMPLIED SWAP ADJUSTMENT MODEL
OR
OR
OR
OR
MIRROR IMAGE PARTY Y PERSPECTIVE
OR
OR
PARTY Y
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49
Silo (DCC) and Transport (CSC) Currencies
1
Required by
the SCSA + ISA
USD
Designated Collateral Currencies (“Silos”)
EUR
2
JPY
GBP
Determined by firmspecific ALM
considerations, not the
SCSA
Required by
the SCSA + ISA
4
5
EUR
..etc..
G17
Convert to a Collateral Settlement Currency
(“Transport Currency”) and Net
3
USD
CHF
Settle the Net Transport Currency
Amount
Re-convert to Silo currencies
JPY
GBP
CHF
..etc..
G17
Compute and pay interest at OIS on Silo balances of collateral
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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
Collateral Amount Physically Moved
PARTY X
USD 140,072,400
PARTY Y
Interest Obligations
PARTY X
EUR 1,071,000
JPY (28,005)
CHF (420)
GBP (5,700)
PARTY Y
USD 6,400
• Which implies two important actions for the parties…
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52
Balances must be manufactured
• The actual physical movement was USD 140,072,400.
• The implied DCC silo balances were however…
Implied Silo Balances
PARTY X
EUR 100mm
JPY 5mm
CHF 2mm
GBP 6mm
PARTY Y
USD 8mm
• 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).
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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.
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54
Baseline funding and collateral flows
PARTY X
EUR 100mm
7
4
EUR 100mm
3
EONIA
8
EUR 100mm
Net Interest
5
Zero
Party Y Funding Trade
Party X Funding Trade
Collateral
Flows
PARTY Y
EUR 100mm
2
EONIA
EONIA
9
EUR 100mm
6
Net Interest
1
EUR 100mm
Zero
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55
Netted settlement collateral flows (EUR silo only)
Tom/Next Swap
PARTY X
USD 144,102,400
4
EUR 100,000,000
EUR 100,000,000
8
USD 144,102,400
3
12
Party Y Funding Trade
Collateral
Flows
PARTY Y
USD 144,102,400
2
EONIA
Basis Difference
USD 144,100,000
Cash Difference
13
1
Fed Funds
7
9
USD 144,100,000
10
USD 144,102,400
5
EUR 100,000,000
EUR 100,000,000
EONIA
11
6
Party X Funding Trade
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56
Economics
PARTY X
PARTY Y
Receive EONIA 3,635
Pay EONIA
(3,635)
Receive EONIA 3,635
Pay Fed Funds (1,001)
Cash Difference (2,400)
Net
Net
Zero
234
(Cross-currency basis)
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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 crosscurrency 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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60
SCSA program plan
Q4 2011
Q1 2012
As of February 28, 2012 - subject to change
Q2 2012
Q3 2012
Q4 2012
Q1 2013
Phase 1 - Pathfinder Implementation for Volunteer Firms
JAN
1. Commercial Design
Stream
FEB
MAR
APR
Commercial
Design
Legal Doc Drafting
3. FPML Stream
FPML Design
5. ISDA SCSAFIX
Stream
ISA
Details
JUL
AUG
SEP
OCT
NOV
DEC
Arrows illustrate certain key
dependencies
Counsel
Review
Infra Spec
Market Infra
Development
Design
Internal
IT Change
Design
ISDAFix SCSA
Build
Local Counsel Opinion Updates
Test
Prep
6. Execution
Stream
7. Education and
Regulatory
Outreach Stream
JUN
Continued Business
Technical Input
2. Legal Stream
4. Infrastructure
Stream
MAY
Market
Testing
Adoption
Design
Market
Education
Market
Education
Execution
Phase 1
Live Date
August 10
Program critical path
is outlined in blue
Bilateral pairs of firms
may execute the SCSA
at any time after
August 10
Market
Education
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
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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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