transactions can also be collateralised in a similar way to repos through a CSA or Credit Support Annex agreement. CSAs provide the terms of a bilateral agreement between two counterparties that allows for collateral to be posted between them to secure the derivative. The CSA is an annex to the ISDA Master Agreement between the two parties. Standard ISDA and CSA agreements are provided by the International Swaps and Derivatives Association Inc., although in practice all ISDAs and CSAs contain some variation in terms and conditions and this has recently prompted ISDA to propose a standard CSA agreement (ISDA, 2011). There are two main versions of the ISDA master agreements, known by their publication dates in 1992 and 2002, respectively, and these will be discussed in more detail in Chapter 3. The settlement conditions embodied in these documents do have an impact on recovery rates.
Derivatives can have both positive and negative mark-to-market values. Hence, most CSA agreements provide support for both counterparties to post collateral, if required, during the lifetime of the transaction or portfolio of transactions if a netting agreement is in place. There are a number of key parameters associated with CSA agreements that control the amount and timing of collateral postings and these are described in Table 2.1. CSA agreements significantly reduce counterparty credit risk but do not eliminate it entirely. The risk is reduced, however, to the discrepancy between the value of the derivatives and the value of the collateral at the time default is recognised. In practice there will be a period between the date on which the last collateral is received and the date when the position is closed, even if the call frequency is daily. Both derivative and collateral value could vary in this period. Care must also be taken if there is a relationship between the counterparty and the collateral that is posted. If there is an adverse relationship this could lead to significant wrong-way risk in which the counterparty defaults and the value of the collateral declines sharply. One significant feature of most CSA agreements is that the collateral can be rehypothecated or reused by passing on to other parties in support of other CSA agreements.17
Table 2.1 Key CSA parameters.
In some transaction types such as those linked to commercial real estate or project finance the derivatives form part of a financing package that includes loans and other facilities. Frequently these transactions are secured on an asset such as, for example, a building or railway rolling stock in the case of train leasing transactions. In these cases, should the counterparty default then the derivative originator will be able to claim the assets used to secure the financing. Security thus acts in a similar fashion to financial collateral under a CSA, although it is not rehypothecable in most cases. Unlike a CSA, however, no further margin call can be made so a risk of loss will occur if the value of the financing package exceeds that of the security.
The security itself may also vary in value, so commercial real estate may lose value in an economic recession. For example, consider a shopping mall provided as security against a loan. If the shopping mall performs well then all of the shops will be rented and the shopping mall owner will have no difficulties paying off the loan. If, however, the shopping mall performs badly with many unrented shops and worse than expected income the shopping mall owner may face difficulty making payment on the loan. If the shopping mall owner defaults then the bank will receive an asset which is already under performing.
The asset may secure more than one set of financing transactions or the package itself may be syndicated among a number of banks leading to additional complexity.
2.4.3 Central Clearing and Margin
Central Counterparties or CCPs have been seen by regulators as a means of reducing counterparty credit risk in the aftermath of the 2008 credit crisis.18 In reality CCPs have been a feature of the market for many years in the guise of clearing houses associated with exchanges. The London Clearing House,19 for example, was formed in 1888 to clear commodities contracts and started clearing financial futures for London International Financial Futures Exchange (LIFFE) in 1982. CCPs now provide clearing for standardised derivative contracts such as interest rate swaps and credit default swaps and in 2009 the G20 leaders mandated that all standardised OTC derivative contracts be cleared by the end of 2012 (Financial Stability Board, 2010). While regulators and world leaders have seen CCPs as critical to reducing system market risks (G20, 2009), others have suggested that CCPs themselves lead to systemic risks (Duffie and Zhu, 2011; Kenyon and Green, 2013c).
Central clearing operates in much the same way as a bilateral CSA contract in that collateral must be supplied to support the movements in the mark-to-market of the portfolio of derivatives. This collateral is known as variation margin in the context of clearing. The frequency of calls for variation margin is typically daily. The rules of individual CCPs vary but considering LCH.Clearnet SwapClear as an example, three additional elements of margining are present: initial margin, liquidity multipliers and default fund. The initial margin is similar to initial margin in CSA agreements in that it must be supplied independently of the current mark-to-market of the counterparties' derivative portfolio. However, LCH.Clearnet Swapclear specifies the initial margin as a dynamic quantity with its PAIRS methodology (LCH, 2012e) using a historical Value-at-Risk measurement. Significant intraday market moves can trigger margin calls for additional initial margin (LCH, 2012b). For positions with large net risk, LCH.Clearnet SwapClear specifies a series of liquidity multipliers to increase the margin position to reflect the limits of market liquidity should the position be required to be closed out completely (LCH, 2010b). Finally a default fund has been created from contributions from all large clearing members to allow the clearing house to survive one or more defaults by clearing members (LCH, 2012a).
Only standardised OTC derivative contracts can be cleared through CCPs. In response to a desire that all transactions between significant financial institutions be margined, the Basel Committee on Banking Supervision has issued a consultation document that will enforce similar rules on OTC derivatives traded between financial institutions (BCBS, 2012h). Most of these contracts are currently traded under CSA agreements and hence are already subject to collateral support. However, the proposal will add the requirement for both counterparties to post initial margin, although there will be no additional posting requirements such as for CCP default funds.
2.4.4 Capital
Collateral can be viewed as a means of ensuring that the defaulter pays in the event of a default. Capital, in contrast, is a way of holding sufficient reserves to enable the non-defaulting entity to manage the loss arising from the default. Capital therefore is a mechanism in which the non-defaulting party ‘pays’ for the default. Regulatory capital is the amount of capital that a financial institution must hold in order to satisfy its regulator. The Basel Accords are a series of regulatory frameworks that provide a methodology for calculating the amount of capital required to support banking businesses that have been proposed by the international body the Basel Committee on Banking Supervision within the Bank for International Settlements (BCBS, 2012a). There have been four major developments of the regulatory capital framework, known as Basel I introduced in 1988, Basel II introduced in 2006, Basel II.5 introduced in the immediate aftermath of the 2008 financial crisis and Basel III introduced in 2010 for implementation on 1 January 2013 (BCBS, 2012d). Implementation of the Basel framework is at varying stages globally with the European Union being one of the most advanced through Capital Requirements Directive 4 or CRDIV. The impact of capital on pricing derivatives is discussed in Chapter 12.
2.4.5 Break Clauses
Many OTC derivative contracts contain one or more break clauses that provide for the early termination of a derivative contract. There are two types of break clause, mandatory and optional. A mandatory break clause terminates the trade prior to the natural maturity date, with the remaining value of the derivative
Now called
