As 2012 drew to a close, Goldman Sachs was involved in the first trades using the new standardised credit support annex (CSA), a document that had been in the works for two years. That was entirely appropriate. Goldman played an active part in the design of the new CSA, and it stemmed from a radical change in risk management and valuation practice that the US bank was first to embrace, back in 2007. The bank has never taken credit for that publicly and still shies away from it today. In part, that may be because the upheaval in market practice that followed was also controversial, giving rise to valuation disputes, hurting liquidity and even holding up the shift to central clearing – Goldman’s argument is that this was necessary pain, and other market participants accept that. What angers some is the belief that the US bank also profited during this upheaval. The change was sparked during the first phase of the crisis, when the spread between Libor and overnight indexed swap (OIS) rates diverged dramatically. The industry had plenty of other issues to worry about at the time, but one technical implication was that over-the-counter trades were being valued incorrectly – Libor was the universally applied discount rate, but the OIS rate was what one counterparty would pay to another on cash collateral it had received, with the specific overnight rate being determined by the currency of the collateral being posted (Risk March 2010, pages 18-22). As a chasm appeared between Libor and OIS rates, it began to dawn on some in the industry that $393 trillion of interest rate swaps would need to be revalued. Officially, Goldman Sachs says it is likely that several banks noticed the problem at the time – but clients and other dealers say the US bank was the first to accept the implications and to grasp the nettle. Kostas Pantazopoulos, global head of interest rate products at Goldman Sachs, says using Libor to discount derivatives was acceptable when the spread between Libor and OIS was very small and reasonably constant, but when the Libor-OIS basis started widening in the third quarter of 2007, people started to take notice. “It became apparent to us and a number of other market participants that this is an item that is quite volatile, that the basis exists and anyone who cares about risk management should pay close attention to it,” says Pantazopoulos. While other houses may have noticed the problem, doing something about it required a big investment in technology and a thorough overhaul of bank risk systems to allow individual desks to look at the implications of switching to OIS discounting – something Goldman Sachs completed in 2008. Other dealers went through OIS-related swap revaluations in 2010 and 2011, announcing impacts of anything from a $176 million gain at Morgan Stanley to a €120 million loss at Crédit Agricole (www.risk.net/2068755). “Based on the observables, a number of institutions were at least theoretically aware of the OIS issue in 2007. What was not clear at the time, but eventually crystallised later, was which institutions would be able to make the necessary technology investments. The mathematics and theory behind it is reasonably straightforward – what is more complicated is how to reflect that all the way through the risk management systems,” says Pantazopoulos. Dalinc Ariburnu, head of fixed-income, currency and commodity sales for Europe, the Middle East and Africa at Goldman Sachs, says the bank had been vocal about moving to OIS discounting since 2007, making big efforts to reach out to its clients – holding a valuation conference in early 2008, for example. While the bank declines to say it was first to spot the issue, Ariburnu says Goldman Sachs should get some credit for the way the market has adapted. “Given all the standardisation in the CSA and the current new environment, we believe our efforts have proved successful and we’re very happy about that,” he says. Other market participants back that up. The head of asset and liability management at a big European pension fund says Goldman Sachs was one of the first institutions to explain in detail the implications of the new discounting orthodoxy and to educate the fund on how to manage the risk. Revaluing the client’s portfolio resulted in a loss for the bank, but the trader says Goldman was willing to swallow that hit. The same altruism was not on display in the bank’s dealings with its peers, sources at other institutions say. One of the knock-on consequences of the new discounting approach was that many existing trades became difficult to value, because the existing CSAs that govern collateral posting between two counterparties often allow collateral to be chosen from a negotiated list. As such, if a firm decides to stop posting US dollars and start posting euros, the discount rate will also change – from the federal funds rate to the euro overnight index average. In theory, a rational counterparty will always post whatever currency is cheapest for it to deliver at any point in time – enabling a discount curve to be constructed from expected forward interest rates – but counterparties are not always rational. Practical issues, like the availability of a currency or a back office that is not in tune with the new reality, may come into play. And there is still no consensus on what discount rate to use when posting non-cash collateral. The result has been a spike in valuation disputes, creating a barrier to the novation of trades from one counterparty to another, and an obstacle to the backloading of portfolios into clearing houses – where valuation practices are different and the resulting shift in the net present value of the portfolio can be significant (Risk March 2011, pages 18-23). This new environment also allowed games to be played. The sharpest dealers tried to ensure they were always receiving collateral on which they would pay a low rate and were posting collateral on which they would be paid a high rate – optimising the value of the optionality in the CSA at the expense of their counterparty. That was a practice many banks engaged in, but Goldman Sachs is said to have been first to employ it and, rightly or wrongly, to have been best at it. For some of its rivals, that’s fair enough – envious senior traders at other institutions say they would have done exactly the same if they had been able to – but for others, there is something unseemly about it: collateral posting should not have become a profit centre, they complain. Pantazopoulos disputes the suggestion that Goldman was trying to make money, saying the bank’s motive was to manage risk prudently. Ariburnu adds that the fact the market has converged to using OIS proves the point. “If it had turned out that some parts of the industry continued with OIS and some with Libor, then it could have been perceived as some dealers taking benefit of the situation. But the fact the market has converged to OIS has proven the critics wrong,” he says. That convergence passed its latest – and arguably most significant – milestone in December, with the arrival of the standardised CSA, which is designed to eliminate the valuation issues that have arisen from the move to collateral-adjusted valuation (Risk December 2012, page 9). Trades under the standard CSA are collateralised in the same currency as the transaction itself – an identical approach to that used by OTC derivatives clearing houses – with the trades discounted using the relevant OIS rate for that currency or an agreed alternative if a liquid curve doesn’t exist. That removes the problems created by CSA optionality, but creates another. All trades have to be assigned to one of 17 currency silos, meaning counterparties could end up posting 17 separate currencies back and forth throughout the day, leading to cross-currency settlement risk (Risk September 2011, pages 24-27). In response, the standard CSA employs what it calls an implied swap adjustment methodology, allowing each counterparty to net the various collateral flows into a single payment in one of seven ‘transport’ currencies: Australian dollar, Canadian dollar, euro, sterling, Swiss franc, US dollar or yen. It sounds complicated, but Pantazopoulos says the development of the standard CSA is a big step for the market and will help support the industry’s move to central clearing over the next 12 to 24 months. “It’s a very uniform framework and we are definitely supportive,” he says. Dealers and sophisticated investors are likely to be part of the early push towards using the standard CSA, he says, with other investors taking it up gradually. As well as helping to lead and shape these changes, Goldman stands apart this year in its day-to-day market-making business, with clients praising the bank for its willingness to take on the large, long-dated – and uncollateralised – trades that are a staple of much corporate derivatives business. This seems out of step with the rest of the industry, which is working hard to restructure, novate or simply avoid exactly this kind of transaction, but Goldman Sachs says the industry’s new awareness of the costs involved in these deals mean it is now possible to get a fair return from them – and the US bank’s unwillingness to compete for what it saw as underpriced business in the past means it has been able to add to what was a reasonably light inventory. “Anytime we need a smooth transaction either related to the currency or to the maturity – for example, a 30-year maturity in the US market in a size of $1 billion – it really helps not to ask too many banks in the market, and we know Goldman Sachs is one of the banks that could easily take such a transaction without showing it to the market,” says a derivatives trader at one big European corporate. The key to Goldman Sachs’ ability to take these trades on is that it doesn’t have a legacy book full of uneconomic trades, the bank claims – it has been pricing for what is now known as credit valuation adjustment and funding valuation adjustment before other dealers or regulators became sensitive to these costs. As a simple example, the bank says the two adjustments should have added around 10 basis points to the price of an uncollateralised 10-year swap with a BBB-rated counterparty at standard market sizes. Other institutions were willing to ignore these issues, typically pricing the firm out of the market. Today, prices have reached a level where Goldman Sachs feels comfortable, Ariburnu says. “You can see a more aligned pricing of these types of instruments compared with before. There is more awareness of the cost of capital and more sensitivity around business selection. Every firm is being very careful about how it allocates its capital,” he says....
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