Multi-currency CSA chaos behind push to standardised CSA

A major split has emerged between dealers over how to price derivatives backed by multi-currency CSAs. Some banks are looking to arbitrage disparities in valuations as a result, causing back-loading of trades to central counterparties to slow to a trickle. A new standardised CSA may be the only way forward. Nick Sawyer reports

"It's difficult to stand in front of regulators and say the over-the-counter derivatives market is functioning well when we can’t even agree how to price a plain-vanilla interest rate swap.” So says one global head of interest rate derivatives at a major bank – and his concern is repeated again and again across the industry. Once seen as the simplest derivatives instruments to price, the major dealers now realise even plain-vanilla interest rate swaps can be exceptionally complicated to value in certain circumstances. So complex, in fact, that there is little consensus on how to do it.

The problem centres on deals that allow counterparties to post collateral in multiple currencies and assets – in other words, trades backed by multi-currency credit support annex (CSA) agreements. This choice of collateral is an option that should theoretically have a value to one counterparty or the other, but dealers are split on how to price it – or whether it should even be priced at all. The result is a mixed bag of pricing practices and little consensus from one bank to the next.

“The consensus is that there is no consensus – but I don’t think there even can be. It is difficult to come up with a theoretical process that covers all the issues correctly,” says Simon Wilson, head of euro swaps trading at Royal Bank of Scotland in London.

This has some major implications. Perhaps most seriously, dealers are refusing to consent to some requests from other banks and clients to back-load existing trades on to central counterparties (CCPs). These clearing houses tend to have simpler collateral practices, based on single currency, cash-only collateral – and any shift in collateral terms as a result of a move to central clearing can have a major net present value (NPV) impact in favour of one counterparty, amounting to millions of dollars. In fact, some dealers claim certain firms have looked to arbitrage these differences in recent months, seeking consent from their counterparties to back-load hand-picked portfolios of trades on to CCPs, knowing they will be able to benefit from what can be a significant difference in valuation.

“Decisions based purely on seeking carry profit and loss from transferring between different collateral regimes will limit the ability to back-load trades into a central clearing environment, which I don’t think is the intention of regulators and could increase systemic risk,” says Nick Hallett, head of cross-currency swaps and rates derivatives funding at Barclays Capital in London. 

The trouble emerges in deciding what discount rate to use to value the swap. The vast majority of dealers now agree that collateralised trades should be discounted using the relevant overnight indexed swap (OIS) rate, determined by the currency of the collateral being posted (Risk March 2010, pages 19–23). So, a trade based on a CSA that stipulates the posting of dollar cash collateral should be discounted using the federal funds rate, regardless of the currency of the underlying swap transaction.

However, this becomes hugely complex when a trade is backed by a CSA that allows the counterparties to post collateral in a variety of currencies and assets. Most dealers agree the discount rate should in theory be based on the cheapest-to-deliver collateral. Therefore, if a dollar interest rate swap is transacted between two parties, and the CSA stipulates dollar, euro and sterling collateral can be posted, the bank would consider what collateral is cheapest to deliver. If euro is cheapest, then the euro overnight index average (Eonia) should be used as a discount rate.

“You have to assume the counterparty will post what is cheapest to them. More and more people are waking up to this, and I don’t think there are many instances of inefficient posting currently, certainly not among the major dealers,” says Fredrik Gentzel, head of credit portfolio management and prime brokerage for global rates and commodities at Deutsche Bank in London.

But what is cheapest now may not remain so over the entire length of the trade, meaning dealers ought to look at the discount curves for each of the eligible collateral types in the future, swapped into a single currency for comparison purposes, and consider what the cheapest-to-deliver collateral would be at each point in time – in essence, creating an intrinsic valuation curve. The final theoretical step would be to consider how this could change as market conditions alter – the time value of the option.

While there may be loose agreement on the theory, market practice is altogether different, with even the major dealers taking a variety of approaches to pricing trades based on multi-currency CSAs. Ten major global banks were willing to share with Risk on a confidential basis how they approach multi-currency CSAs. Several say they consider the cheapest-to-deliver at the inception of the trade and use this over the life of the transaction. So, if euro is currently cheapest to deliver now, Eonia would be used as a discount rate for the full term of the trade – possibly with a subjective adjustment to account for the option component. “Just choosing one currency is the more practical and that gives you the biggest bang for your buck,” says one interest rate swaps trader at a European bank.

Others are going a little further, using the intrinsic valuation curve. In other words, if the discount curves on a forward basis suggest euro will be cheapest for the first 10 years of a 30-year trade, but then dollar will become cheaper for the back-end of the transaction, they will use Eonia followed by the federal funds rate.

The final theoretical step is the most difficult, and only one or two banks are believed to be attempting it. The complexity is not in developing the model itself, but more in hedging the exposure, say market participants. “Theoretically, it is not difficult to put together a model – it would be an extension of a stochastic basis model where you have more than one basis,” says Vladimir Piterbarg, global head of quantitative research at Barclays Capital in London. “The huge question is whether you are able to execute the hedging strategy required.”

Dealers suggest this approach would require an OIS cross-currency basis swap market, as well as options on those basis swaps – markets that are not currently observable. Banks would also need to consider the correlation between various overnight rates – again, something that cannot be traded. One dealer suggests it might be possible to hedge based on client flows and other internal businesses – although others are sceptical.

“It is quite a complex calculation, and the instruments you would need to be looking at to perfectly hedge your risk do not trade in the market,” says Christophe Coutte, deputy global head of flow fixed income and foreign exchange at Société Générale Corporate and Investment Banking in London.

Another impediment is that counterparties may not in reality be able to exercise the option and freely substitute existing collateral with new, cheaper assets, dealers say. Certainly, banks are becoming much more aware of the issue, with many developing stronger ties with their operations departments to ensure the most efficient form of collateral is posted at all times. However, the English law CSA requires consent of the receiving party before any substitution of posted collateral can be made. In practice, some dealers have been refusing to consent to the switch.

“We were in a fairly heated dispute with another dealer and threats can escalate fairly quickly. We wanted to substitute collateral, but we had our legal teams look at it and we felt it was a grey area,” says one New York-based head of interest rates trading. “After that, we pulled all the CSA documents and reviewed the language one by one then really connected with our collateral department. We realised that if other dealers are recognising the option and acting on it to us, and if we are not doing the same thing, then that lack of symmetry creates a loss of value over time.”

Other dealers confirm they have refused requests for collateral substitutions – a development that has caused anger among some, who argue the requirement for consent was not written into the CSA documentation to prevent any and all requests for switches. “Technically you have to have consent, but in reality everyone always does, and it is really just a legal device to avoid re-characterisation risk. Some firms have got the wrong end of the stick and deliberately use this as a stick to beat one another with by withholding consent when the substitute collateral being proposed is disadvantageous,” says one senior industry official.

Consequently, some say it is difficult to fully price the collateral switch option in practice, even if it can be measured theoretically. “The pricing of the optionality is very complex, requiring several assumptions to be made on volatilities and correlations. Given this, and the fact that counterparts have the legal right to refuse collateral substitution, I do not believe it is a good idea to give real value to this optionality. It is more useful as a qualitative/theoretical assessment of your exposures,” says Gentzel at Deutsche Bank.

Disputes have emerged in other areas, too. Regulators are keen to push most of the over-the-counter derivatives market on to CCPs – but some dealers are refusing to grant consent on requests from other banks and clients to back-load existing trades if they result in a negative NPV impact for their firm.

This valuation change is a direct consequence of any modification in collateral terms resulting from the move to a CCP. London-based clearing house LCH.Clearnet currently requires variation margin on interest rate swaps to be posted in cash, in the currency of the underlying transaction, with the relevant OIS rate used to discount the trade. So, a dollar swap transacted under a CSA that allows the posting of euros and dollars might be discounted using Eonia, assuming euro is the cheapest to deliver. On moving to central clearing, the swap would be discounted using the federal funds rate – and this could have a significant impact on one counterparty, amounting to millions of dollars in some cases.

“The reality is that for at least a period of time, we’re going to have a significant part of the market cleared and a significant part of the market remaining bilateral, and it would make risk transfer between the bilateral and cleared parts of the market much easier and more liquid if both had similar margin terms – or put another way, if the margin terms didn’t provide an impediment to transferring risk between those two segments,” says Michael Clarke, global head of counterparty risk operations and market infrastructure strategy at UBS, and chair of the International Swaps and Derivatives Association collateral steering committee.

Dealers agree the impact on NPV is smaller than the changes that can emerge from a switch from Libor to OIS discounting. But it can still run to several million dollars on individual transactions, and tends to be more noticeable on longer-dated trades. “For every trade that is migrated, there will be an NPV impact – positive or negative – and a change to the contractual position. Therefore, there are likely to be winners and losers, especially when dealing with certain long-dated trades. The issue for the market to consider is to what extent those negatively affected can be incentivised to make the switch,” says Neh Thaker, global head of structured rates and head of local currency trading for Europe, the Middle East and Africa at Bank of America Merrill Lynch.

Several dealers say they ask for compensation in circumstances where the NPV impact for them is negative – something that has caused friction with some clients, which don’t yet understand where these costs come from. “Unfortunately, some of the customers took for granted the assignment process and didn’t understand at the beginning when some of these were turned down. Traders in banks said ‘no, you cannot assign this one because this is a cost to us and there will be an impact on your price’. That made customers unhappy,” says Coutte at SG CIB.

One dealer says the opposite is also true – compensation should be paid to the counterparty when the benefit of any change in collateral terms is in its favour. “In the event where we back-load trades and we see a gain, we can pay out a hard fee for that,” says one London-based swaps trader.

The difficulty comes in standardising how this fee is paid and, of course, calculating the size of it – no easy task given the lack of consensus in pricing multi-currency CSA trades to begin with. “A market standard approach for dealing with this hasn’t emerged yet. I think the problem is banks that are going to be clearing are quick to charge when it is a loss and less quick to pay out when it is a gain. This causes friction with the clients, and there are a good number out there that just don’t understand the topic yet. So if you tell them you are not going to do it, it is obviously going to create a whole lot of friction,” says one London-based head of interest rate options trading.

The complete lack of consensus in valuation – and the disputes this can cause – has prompted a group of dealers to work towards drawing up a new, standardised CSA. One feasibility study is taking place under the auspices of Isda, while a parallel stream of work is under way at the Association for Financial Markets in Europe (Afme).

“The rationale behind this initiative – and it is in the very early stages – was that it was felt having multi-currency/multi-asset CSAs leads to complexity, arguably unnecessary complexity, in terms of bookings, operational processes and the overall valuation of the assets covered by the CSA itself. This complexity arises not just from the multi-currency variable, but also bespoke minimum transfer amounts, thresholds and other variables,” says Julian Day, head of market infrastructure at Isda in London. “Over time, we’d like to merge the two working groups because, ultimately, the CSA is an Isda document. There is also the potential for it to be a duplicative process and having two parallel conversations would result in a less efficient process.”

Both working groups are considering a proposal, originally suggested by Goldman Sachs, which would broadly mirror the clearing house model. In other words, trades would be sub-divided into currency buckets, with only cash collateral in that currency allowed to be posted. So, counterparties would only be able to hand over dollar collateral for a dollar-denominated swap, and this would be discounted at the federal funds rate.

The proposal would eliminate the optionality embedded in CSAs – and the complexity surrounding the pricing of such transactions. However, a number of operational issues need to be addressed, which are being considered by the two working groups. Foremost among these is settlement risk, which can arise from posting collateral back and forth in those particular currencies.

“The foundation concept is that you subdivide your portfolio into currency-specific silos and then compute a corresponding currency-specific collateral amount, which covers the counterparty risk and aligns funding. But in practice it is a lot more complex, because if you just did that, you would fragment netting sets and create multiple flows of collateral in different currencies, which introduces settlement (Herstatt) risk,” says Clarke at UBS.

Dealers are believed to have considered CLS – a service that tackles settlement risk in the foreign exchange market – but decided against pursuing this option due to the time it would take to get a solution to market. An alternative option would be to net all collateral flows between counterparties into a single currency, using overnight currency swaps to adjust the interest paid on the collateral.

“We actually have a couple of solutions for that. One is a sort of mechanical idea to use a sort of escrow facility and the other is probably the more likely to be used, which is a computational method that gets you to effectively synthetically create the economics of settling those currencies individually, but still allows you to settle a single currency for convenience,” says one dealer on the working group.

A similar sort of approach could be used for extending the collateral that can be posted by clients. Pension funds have been vocal in their criticisms of the move to clearing, on the basis that they would struggle to post cash variation margin (Risk November 2010, pages 37–39). Any switch to a single currency, cash-only CSA in the OTC market would be sure to upset these clients further.

“We can essentially present our clients each day with a collateral menu, which shows the prices at which we will lend or borrow collateral every single day. If the person with whom we are trading does not want to or is unable to collateralise in that base cash-only scenario, they have the optionality to collateralise with whatever they want, but importantly the economics of that non-homogeneous collateralisation are only realised mutually between those two counterparties on an accrual basis, and that doesn’t enter into the long-term mark-to-market nature of the trade,” says one London-based head of swaps trading.

Another bank – HSBC – has also put forward two revisions to the proposal. One would make it explicit that counterparties could choose to settle in a single currency. The other would incorporate an option to clear through a CCP. Essentially, this would involve a clause being written into the new CSA that would allow either counterparty to load the trade on to a CCP in future, without requiring the consent of the other party.

“We put this forward for two reasons,” says Elie El Hayek, global head of rates at HSBC in London. “The first is to be more compliant with what we promised to regulators, which is to move more towards central clearing. The second is to have a clear dispute resolution protocol, which means if the deal is clearable and the counterparties don’t agree on the valuation, either can put it in the clearing house. What is more important to HSBC is a clearing-like valuation as a protocol for dispute resolution under this new CSA, rather than physical clearing.”

However, some dealers question the value of this clause. “At the point you clear, you put another bank into a contingent risk position and also a credit position, and an initial margin position, so there is just no way the risk department of our bank could sign up to it,” says the head of interest rate options trading.

Others point to difficulties in pricing. “It creates the possibility of people doing trades now in the anticipation that the product would not be cleared, but if it can be cleared in future, one party has the option to mandate it to be cleared at some future point – so how do you price that?” asks the senior industry official.

Despite mixed views on this point, El Hayek says there is broad agreement among dealers on the need for standardisation. “The philosophy is to make the market much more transparent in terms of valuation and to make things much easier for clients for novation and to have a clear protocol for disputes. The spirit we want to put forward in a new standard CSA is to be as close as possible to the clearing houses. The discussions have been moving forward reasonably well.”

Some dealers expect a recommendation to be made by the working group by the end of March. Others think that may be ambitious. Once a recommendation has been made, it would need to go through the collateral steering group of Isda, and possibly on to the association’s board. As such, Day at Isda says a quick resolution may be unlikely. “While this is something the industry is actively engaged in, it is still very much in the research phase rather than in the developmental phase. I think it will take some time to bring the project to implementation, as having industry consensus on this issue will be paramount.”

While the working group comprises a small group of dealers, any resulting CSA would be open to all market participants. Some have also suggested the new standardised CSA might be applied to legacy trades – but several dealers suggest this would be totally unworkable. “You can’t enforce a legal change like that on a bilateral contract, and guess what? The bank that is up $1 billion isn’t going to say yes to it. What I think will possibly happen is that the market agrees a CSA going forwards, and then you try to bring old trades on to that CSA on a bilateral basis,” says the head of interest rate options.

Any move towards simplicity in CSAs is likely to be welcomed by regulators, suggest industry participants. Ultimately, though, regulators may need to take a firm hand to ensure the current situation is resolved, and to eliminate the barriers preventing trades from being back-loaded to CCPs.

“The resolution to all these issues is to get better standardisation of CSAs and move towards central clearing, and very clear guidance from the regulators as to exactly how and when that will happen and who for. To be fair, I think that is coming. They have stated their intent, but at the moment there is wiggle room for people,” says Hallett at Barclays Capital. However, he suggests the situation may to some extent resolve itself over time. “Selective back-loading may or may not work once Basel III kicks in, as a bilateral portfolio could be more expensive down the road and everyone back-loads.”

 

The problem of minor currencies

In an ideal world, many dealers say the new credit support annex (CSA) would only allow collateral to be posted in cash, in the currency of the underlying trade. This would then determine the discount rate that would be used. So, a euro-denominated swap would be collateralised with euro cash, and the euro overnight index average (Eonia) would be used to discount future cashflows. This would eliminate much of the complexity currently caused by multi-currency CSA agreements.

That’s all well and good for euro, dollar and sterling – but what of smaller currencies where no liquid overnight indexed swap (OIS) curve exists? There’s no easy answer at the moment.

“Certainly, the minor currencies are an issue, but I suspect a lot of this is circular. If the CSA does become standardised on a certain basis, that could well increase the need for OIS in some bigger markets. Dealers are having to make some assumptions about how to price very minor currencies,” says Nick Hallett, head of cross-currency swaps and rates derivatives funding at Barclays Capital in London.

The current proposal, being discussed by working groups at the International Swaps and Derivatives Association and the Association for Financial Markets in Europe, gets around this problem by creating a set number of currency buckets into which various trades are assigned – with the swap discounted using the OIS rate of the currency bucket.

“There is a theoretical and practical balance here. Theoretically, you should have separate collateral computations for each currency and then use the relevant overnight index for the currency concerned. The reality is this index doesn’t exist in liquid form for all currencies, and even if it did, that model is probably too complex to deal with operationally. So we haven’t finalised the exact structure on this, but it is possible you would have separate computations for the four or five major currencies, and then if there was any exposure that fell into the ‘other’ category, it would probably go into the dollar or perhaps the euro computation,” says Michael Clarke, global head of counterparty risk operations and market infrastructure strategy at UBS, and chair of the Isda collateral steering committee.

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