Counterparties clash over ‘dirty’ CSAs

Dealers and clients struggle to agree optionality value of posting bonds in cash-and-bond CSAs after Eonia conversion

  • Many holders of euro-denominated interest rate swaps were unable to renegotiate their cash-and-bond collateral agreements before the demise of Eonia on January 3.
  • Instead they were forced to rely on fallbacks which substituted Eonia for its risk-free rate replacement €STR plus 8.5 basis points.
  • Some users wish to move the discounting rate to €STR flat to come into line with the market standard for cleared trades.
  • A move to €STR flat would result in exchange of compensation to square up counterparties for the valuation difference between the two rates.
  • Changing the discounting rate for both cash and bonds to €STR flat would make the option to post bonds as collateral more likely, some argue, and they want that change in optionality value to be reflected in compensation levels.

The new year brought a headache for holders of non-cleared euro interest rate swaps – and not from festive overindulgence. Many now face the prospect of renegotiating collateral agreements known as credit support annexes (CSAs) after the reference rate, Eonia, ceased on January 3.

The problem affects counterparties who failed to voluntarily rehitch their CSAs to the replacement rate, €STR. These holdouts have seen their contracts forcibly flipped to €STR plus a spread of 8.5 basis points, in line with official fallback language inserted into deals in advance of Eonia’s demise.

But many counterparties are unhappy about this. They would prefer their uncleared swaps to reference the same rate as their cleared swaps, namely €STR flat. However, this would create winners and losers from the switch. So counterparties are haggling over the level of compensation payable by the winners to the losers.

“We’re trying to negotiate to reach an agreement which is beneficial to both parties, but if we are not able to agree on a number, why should we go to €STR flat and lose money? It doesn’t make any sense,” says Daniel Cremades, head of credit and funding valuation adjustment at BBVA.

Calculating the compensation for swaps contracts with standard CSAs is straightforward. The amount would be based on an 8.5bp move in the discount rate for the swap and the collateral interest rate, known as price alignment interest (PAI).

But it’s a different story for collateral agreements that give the users the right to post cash or bonds as variation margin, known as cash-and-bond CSAs. Counterparties argue that the optionality embedded in these CSAs has a value. They just can’t decide what that value is.

“We propose one quantity, and the counterparty proposes some other quantity. And if they are too far apart, then we’ll go to the 8.5bp solution,” says Cremades.

It’s hard to say how many swaps contracts are affected. As the clock ticked closer to the end-of-year Eonia cessation, banks and clients were busy renegotiating any unresolved deals.

Dutch pension fund advisory firm, Cardano, says it agreed to switch all its CSAs to €STR but was unable to finalise a compensation amount for every deal prior to year-end. These contracts shifted to €STR plus 8.5bp and the company says it will revisit those CSAs “when there is a new opportunity”, according to Max Verheijen, director of financial markets at the firm.

One head of trading at a European pension fund says they transitioned all their cash-and-bond CSAs and that the switchover was smooth. A head of derivatives at a UK asset manager says the majority of their cash-and-bond CSAs have moved to €STR flat while the rest have moved to €STR plus 8.5bp.

Speaking late last year, Mickael Crabos, head of asset-liability management at Crédit Agricole CIB, said: “There is an acceleration of renegotiation [of CSAs] especially for Eonia. We are in the process of modifying the contracts so as not to rely on the fallback.”

Pick and choose

Cash-and-bond collateral agreements are not a standard type of CSA, and are typically referred to as ‘dirty’ collateral agreements due to their numerous bespoke terms. They tend to be used by the buy side, such as pension funds and asset managers.

“This is definitely not a standard contract,” says Crabos. “So, it does concern only a few counterparties, but it could concern some large ones which could explain the main worry most of the dealers have.”

Under a CSA, counterparties can agree on the type of eligible collateral posted as variation margin, and the PAI applied to each type of collateral the receiver of the margin pays to the poster. The discount rate, which is used to calculate the present value of future cashflows of the swap, in theory should match the PAI rate on the collateral.

In the case of a euro cash-only CSA, the discount rate was Eonia – now €STR – because that is what could be earned by investing the cash in the money markets. In a bond-only CSA that would theoretically be the rate earned by repoing out the bonds posted to the receiver under a CSA.

Before January 3, there were two options available to parties to deal with the cessation of Eonia. They could move to €STR flat with compensation to square up the winners and losers of the trades. Alternatively they could move to €STR plus 8.5bp which is deemed to be equivalent to Eonia and thus maintain the status quo, but risk misalignment with clearing houses.

Clearing houses moved from Eonia to €STR flat for discounting future cashflows and calculating PAI on collateral for euro swaps last July. At the time, a cash compensation mechanism was implemented to even up the winners and losers of the valuation difference.

Compensation was required because the switch from Eonia to €STR flat resulted in an 8.5bp reduction in the discount rate. This benefited in-the-money counterparties by inflating the size of their mark-to-market position. Accordingly, any gains from the move were handed to the out-of-the-money counterparty to even things out.

Wanting to follow the market standard set by the clearing houses, and to minimise the valuation differences between cleared and non-cleared euro swap trades, many dealers have been pushing where possible to move to €STR flat with a similar cash compensation mechanism.

The optionality is very complex to price. The way we consider the collateral is also model dependent. So, in the end, the cash compensation will be very complex to explain, justify and charge in case of switch from Eonia to €STR flat

Mickael Crabos, Crédit Agricole CIB

For a cash-only CSA it’s relatively easy to calculate compensation for an 8.5bp move in the discount rate. But it’s a complex exercise for the small minority of non-cleared swaps users with a cash-and-bond CSA wanting to move to €STR flat. This is because some argue the optionality to post either cash or bonds has value, and that in effect lowering the rate for cash means it’s now more likely that out-of-the-money users could exercise their option to post bonds. In-the-money counterparties therefore argue that the value of the optionality should be taken off any compensation stemming from the 8.5bp change in discount rate.

For example, take a cash-and-bond CSA where the cash was discounted at Eonia and the repo-linked discounting rate for bonds was Eonia minus 10bp. Converted into €STR terms, cash discounting would be €STR plus 8.5bp, and bonds would be €STR minus 1.5bp.

If the cash discounting rate moved to €STR flat to align with the clearing houses, which only take cash as variation margin, and the bond portion stayed at €STR minus 1.5bp, the gap between the two has reduced.

Counterparties will always seek to post the collateral that benefits them economically, so an out-of-the-money party would look to post collateral with the higher discount rate to reduce their mark-to-market liability as much as possible.

In the instance described above, cash would be the cheapest to deliver as the cash discounting rate is 1.5bp higher than the bond repo-linked discounting rate. But as the discounting rates between cash and bonds in the above example are only 1.5bp apart, the probability that a small positive change in repo rates could make bonds the cheaper to deliver collateral has increased.

This means counterparties may be more likely in the future to want to post bonds as collateral instead of cash.

The embedded optionality in these CSAs can be a cost for dealers in certain situations. Take an example where a dealer was in-the-money with a non-cleared cash-and-bond CSA client and had hedged with a cleared swap. If the repo rate rose beyond €STR and the cash-and-bond CSA client switched to posting bonds, the higher discount rate would see the dealer’s in-the-money position reduce in value, but the cleared swap would not change.

This would result in a net loss for the bank, and is a reason why some banks are keen to ensure they are properly compensated for the optionality.

“The probability that the repo rate will be above the cash renumeration increases and hence you will be more prone to post bonds more often in the future than you would have done when the renumeration on cash was still Eonia,” says Verheijen at Cardano.

“If you also have the option to post bonds, and that option becomes more valuable for the other party, I will deduct that from the compensation. So, I will no longer pay you 8.5bp the difference in the Eonia and €STR, but less than that. I will incorporate the additional value that my counterparty has to be able to post bonds,” he adds.

Crystal ball gazing

However, it’s difficult to pinpoint the exact value of the optionality to post bonds as collateral.

Verheijen says Cardano has adjusted the 8.5bp compensation to take into account the optionality by anywhere between 2bp and 7bp, when moving its CSAs to €STR flat.

The head of derivatives trading at a UK asset manager says some banks have sought to model the optionality in greater detail than others, depending on the size of the positions.

“Some of that might be down to the size of the positions, so if the positions are relatively small or the in-the-moneyness is not large, then there’s been a more flexible approach adopted, and others have sought to apply their in-house models more assiduously,” the head says.

In order to calculate the value of the optionality, a counterparty needs to understand the probability of the repo rate rising enough to make bonds cheaper to deliver, throughout the life of the trade.

There firms run into another problem. There are no long-term repo rates that go out to, say, 30 years. Instead, every firm has its own method of calculating where the 30-year repo curve sits.

“There is more alignment in how to approach modelling the long-term repo curve than there was years ago,” says the head of trading at the European pension fund. “But how you model the long-term repo rate is based on a couple of assumptions, and those vary from bank to bank.”

There are other factors in valuing the bond collateral optionality, such as the type of eligible bonds to post, whether they are government bonds or corporate bonds, and the maturity of the transaction.

Indeed, some believe the exercise is so complex that firms may decide not to bother.

“The optionality is very complex to price. The way we consider the collateral is also model dependent. So, in the end, the cash compensation will be very complex to explain, justify and charge in case of a switch from Eonia to €STR flat. In most of these cases, the easiest management of the switch is to maintain equivalence applying the switch from Eonia to €STR plus 8.5bp,” says Crédit Agricole’s Crabos.

Trouble ahead

As counterparties sit down to renegotiate the terms of their euro cash-and-bond CSAs, some see this as an opportunity to clean up these collateral agreements.

“Those [CSAs] that have multicurrency and or bonds optionality are probably driving people to review the reasons why they struck those types of arrangements in the past,” says the head of derivatives trading at the UK asset manager.

In some instances where a CSA is overly complex and parties still want to try and move to €STR flat, Nicki Rasmussen, head of derivatives valuation adjustment at Danske Bank, says this can only be achieved by simplifying the CSA and then trying to move to €STR flat.

“It is, of course, also a good opportunity to discuss whether life would be easier for both parties in the daily dealing and trading if we slimmed down the CSA – either by removing some of the non-cash or reduce it to the absolute minimum necessary types of collateral, the ones you do have and want to use,” he says.

But for others reaching agreement on cash compensation remains the primary focus.

There are several reasons why firms may choose to move their collateral agreements to €STR plus 8.5bp. For some it’s an operational issue: they don’t have the personnel to dedicate to modelling the repo rate and undertake compensation discussions.

For others, it’s purely a complexity issue. Their CSAs are so bespoke that attempting to move to €STR flat and calculating the associated compensation would prove an impossible task.

“In the cases where the counterparty didn’t have the confidence to go through the compensation discussion, even though we have done our utmost to be fully transparent and give as many details as required, there have been some that just preferred to get it over with quickly and with no compensation and maintain the status quo [of €STR plus 8.5bp],” says Danske Bank’s Rasmussen.

Though moving to €STR plus 8.5bp, Eonia’s equivalent, might seem like the easiest solution to the problem now, Cardano’s Verheijen argues it could open up counterparties to new problems when they go to unwind trades under the updated CSA in the future or when they set up new trades.

“If you look at your Bloomberg screens, these are all contracts, all swaps that are discounted at €STR with no additional spreads,” says Verheijen. “So, if you already deviate from that in your CSA, you open up the opportunity to discuss each and every new trade. Therefore, we think it’s in the interest of our clients to stay as close as possible to the market practice, so €STR flat.”

Editing by Alex Krohn

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