Banks pitch auto-resetting CSAs to cut leverage ratio and XVAs

Regular settlement of margin would reduce swaps' residual maturity

Auto-resetting CSAs would help banks reduce leverage ratio costs

European buy-siders are being asked to sign up to a new style of credit support annex (CSA) that would cut bank capital costs by settling and re-striking trades every few months.

Banks would be able to hold less capital using the CSA, because regular settlement would cut down the residual time to maturity of swaps, a key input in the calculation of the leverage ratio. Some of the cost savings could be passed on to clients.

A liability-driven investment (LDI) portfolio manager at a major asset manager based in London says his firm has been approached about putting an auto-resetting CSA in place.

"Let's say you're on a cash-only CSA, the economic flows are similar. If the trade is out of the money for me, I need to post cash collateral anyway, so that's very similar to paying the mark-to-market and collapsing it to zero. The only thing [the new CSA] does is make it explicit."

The fixed rate leg of the swap would reset to the on-market prevailing rate, he explains. The accrued mark-to-market since the last reset would be settled and the cumulative mark-to-market would be updated.

"This is essentially a hypothetical account that records what the collateral posted would have been without any resets," he says. The net receiver of cumulative mark-to-market would pay the CSA rate on that account, similar to the net receiver of cash collateral paying the CSA rate on cash collateral received.

Elsewhere, clearing houses have been exploring similar ideas whereby they would treat variation margin as settlement rather than collateral, as a way to reduce bank capital charges for cleared derivatives.

Automatic resetting is one of three ways banks have come up with to cut down on derivatives capital charges, alongside sunset CSAs and cash-only CSAs – both of which aim to reduce capital charges against non-cash collateral.

Auto-resetting CSAs would reduce capital by bringing down the so-called potential future exposure (PFE) add-on in the leverage ratio. This is calculated by multiplying the underlying notional by a percentage based on the residual maturity of a contract. Long-dated swaps are particularly capital intensive.

Under the European Capital Requirements Regulation, if contracts are structured to settle the mark-to-market and reset back to zero on particular dates, the residual maturity is the length until the next reset date.

A 20-year swap could therefore have a nominal maturity of less than a year. For interest-rate swaps, that would cut the PFE multiplier from 1.5% to 0.5%.

The new CSAs could also reduce banks' valuation adjustments (XVAs), which adjust the cost of derivative trades to reflect implicit costs such as funding, capital and counterparty risk. Banks have been making efforts to optimise XVA charges after they contributed to heavy losses across the industry.

Cutting PFE would reduce counterparty valuation adjustment (CVA) and potentially reduce funding valuation adjustment (FVA), both of which factor potential future exposure into their calculation, says Amir Kia, a London-based senior manager in Deloitte's risk advisory practice.

"The reduction in CVA is almost certain but the reduction in FVA is not guaranteed, though likely," he says. "For an in-the-money trade, even if at every reset the expected potential exposure is zero, the variation margin can increase as the hedge becomes deeper out of money. FVA might not change materially. The hedging for these resetting products needs to be dynamic and much more active than the hedging of non-resetting products."

Banks might struggle to convince some buy-siders of the benefit of auto-resetting CSAs. Simon Wilkinson, head of LDI at Legal & General Investment Management in London, says: "To be honest, it's just one of the many workarounds for the fact that anything other than cash variation margin for CSAs is too expensive from the banks' point of view for them to be able to offer competitive pricing.

"All it means is that instead of needing cash variation margin daily you need it every six months. We can manage our clients' liquidity on a day-to-day basis. All it really does is give you a bit more breathing space in terms of your liquidity but most people can handle daily variation margin."

Meanwhile, a London-based banker specialising in pensions and insurance says the new CSA might add to operational risk.

"I can put an auto-recouponing [CSA] in place today and convince myself that for the next two or three years people are going to know about it. But five years down the line? Who's going to be around to make sure the cash is there to pay if you've got a re-couponing on a negative mark-to-market?" he says.

"If you're in the money, what are you going to do with that cash? [For insurers] from a matching adjustment perspective, it also raises questions about how certain you are on the cashflows."