Some dealers are refusing to trade with clients that opted to sign new collateral agreements to comply with the non-cleared margin rules rather than amending existing ones.
The problem affects end-users that kept their old credit support annexes (CSAs) for legacy positions and signed new agreements to cover trades executed after the March 1 deadline to begin exchanging variation margin.
Those firms saw their portfolios split into two netting sets, each governed by a single CSA. Some banks are now telling clients they can no longer maintain ‘dual netting sets’ of pre- and post-March 1 trades.
“A certain number of our clients were told by banks that they can’t accommodate dual netting sets, and that the client must have its entire pre-existing portfolio under a margin-compliant netting set in order to continue trading,” says Chris Bender, director of regulatory advisory in the global regulatory solutions team at Chatham Financial in Pennsylvania. “Other banks say they can only do it in exceptional circumstances, because it essentially doubles the operational burden for them – two margin calls and exchanging margin under two netting sets.”
The main gripe among dealers is that dual netting sets result in two gross margin postings – even if trades in the legacy netting set offset those in the new one.
“For one of our clients, the bank is looking to just have one netting set that covers both new and legacy trades,” says Brian Phelan, a director at the consultancy JCRA in New York. “This means the bank will be positing more collateral as the client is long options, but it keeps things simple for them.”
Banks say dual netting sets are not a major burden if they are governed by cash-only CSAs. However, most buy-side firms tend to post less liquid assets, such as corporate bonds, and a dual netting set doubles the already higher cost and operational complexity of accepting non-cash margin.
A certain number of our clients were told by banks that they can’t accommodate dual netting setsChris Bender, Chatham Financial
“If you receive US dollar cash, the discounting rate would be Fed funds. But if you receive corporate bonds, a more rigorous rate is some form of corporate bond repo curve, which makes it harder to hedge future fluctuations. It’s also harder to model because you can only observe the front end of the curve. For discounting a 10-year derivative, you’d have to get a corporate bond repo rate out to 10 years, which is a pretty tall order in terms of discounting,” says a derivatives specialist at a bank in New York.
This is particularly cumbersome for banks that typically have one-way portfolios with clients. If a client that was in-the-money pre-March 1 – meaning the bank was posting cash margin to them – puts on a new trade that is out-of-the-money after amending an existing CSA, the present value of the portfolio would be less in-the-money, and the bank would simply pay less cash margin as a result. But if the client put on the same out-of-the-money trade under a brand new CSA set up for trades executed after March 1, the bank would post the same amount of cash margin against the legacy portfolio, and the client could post corporate bonds as collateral for the new trades – creating an additional cost for the bank.
“If you’re suddenly starting from square one with new trades in a new portfolio then there is no cushion before a client might start posting collateral to you,” says the head of rates at a European bank in New York. “Participants might have ignored it before because the portfolios were very asymmetrical in terms of present value and risk, but starting from scratch again makes it more of an issue.”
‘Painful’ pricing adjustments
While some dealers are insisting that clients consolidate their trades under a single CSA, others are willing to accommodate dual netting sets subject to pricing adjustments for clients posting corporate bonds as collateral.
“In certain cases, pricing would definitely be affected,” says the head of rates at the European bank, which continues to trade with clients with dual netting sets. “If the collateral is cash then the client will receive flow pricing, which is near to the dealer-to-dealer market. As soon as you use other collateral you’re looking at a much more bespoke calculation, so you won’t get flow pricing in terms of timing or level.”
The pricing adjustment is generally implemented as a spread on top of the Fed funds rate, which is used to discount trades.
“It’s a painful approach because, depending on the spread on top, the price of given derivative will not be the screen price,” says the head of rates at a second European bank. “Someone will have to adjust the prices on every single inquiry. It’s more work.”
The pricing adjustments can be as high as 100 basis points for some clients, he says.
That may not be enough to convince buy-side firms to give up their old CSAs and move to a single netting set, however. “On the old CSA, if there was a negative mark-to-market and the negotiated thresholds before having to post margin were favourable, then you would want to take advantage of those thresholds and keep a separate netting set,” says Chatham’s Bender. “Most of our clients fell into this category, so it makes sense to keep thresholds in place and put any new trades under a new netting set for in-scope trades executed after March 1.”
There was a very prominent dealer that insisted that there be a new CSA for the new trades and an old CSA for the old tradesWilla Cohen Bruckner, Alston & Bird
Dealers say they warned clients of the complexity of valuing trades with collateral optionality when renegotiating CSAs, and advised them to restrict themselves to posting cash margin.
Clients had other ideas, however. “Some clients tried to introduce more securities into CSAs than they had before, using March 1 as a lever to broaden their CSAs,” says the head of rates at the second European bank.
But buy-side sources say banks were equally difficult in their negotiations with them – insisting the clients sign new CSAs for trades executed after March 1, for instance – which has exacerbated the complexity of exchanging margin under the new rules.
“There was a very prominent dealer that insisted that there be a new CSA for the new trades and an old CSA for the old trades,” says Willa Cohen Bruckner, a New York-based partner at Alston & Bird. “We tried a number of different ways to negotiate but we could not get the dealer to budge.”
The question of dual netting sets and cash-only CSAs could cast a shadow over the industry as dealers continue to finalise collateral agreements with clients. According to the International Swaps and Derivatives Association, only half of in-scope CSAs were compliant with the new margin rules as of April 17, setting the stage for some potentially tricky negotiations over the remaining agreements.