Nov 14, 2012

The ABCs of CSAs

In this video blog, Numerix Host James Jockle, SVP of Marketing and Satyam Kancharla, SVP of Client Solutions explore ISDA Credit Support Annex (CSA) agreements – including what it represents and how it’s used to manage Credit and Counterparty Risk.  Jim and Satyam also discuss the complexities of CSA terms, the imbedded optionality and the implications for liquidity risk.


Numerix Video Blog Transcript – The ABCs of CSAs

Jim Jockle (Host): Hi, welcome to Numerix video blog I’m your host Jim Jockle with me today is Satyam Kancharla our SVP of the Client Solutions Group at Numerix. Hi Satyam –

Satyam Kancharla: Hi Jim.

Jockle: Terms of the day post-election is the fiscal cliff, the second most popular terms popping up in the risk circles is collateral crunch. And if we go back in to July of earlier this year, Basel II, Basel Committee and IOSCO came out saying margin requirements for non-centrally cleared derivatives have been proposed to reduce systemic risk caused by among other things the build-up of uncollateralized exposures within the financial system and the paper is contemplating that margins imposed to all non-centrally cleared derivatives however we have a CSA in place in many, many cases and I think what I’d really like to focus on today is the CSA itself, and almost an ABCs of CSAs.

So Satyam for the audience, what does the CSA represent?

Satyam Kancharla: So the best way to look at CSAs is as an addendum to the main contract. So you have an OTC contract you have a bunch of terms that represent how the swap is going to behave and this is just more terms that were buried in the back office for all these and are just very important right now. Another way to look at it is actually as a derivative, so any derivative has a set of contingent payments that take place depending on certain actions and the CSA actually fits that definition.

So it is in fact a very complicated legal document that defines all of these contingent payouts and it sits behind all of these derivatives that people trade at.

Jockle: Specifically within the context of recommendations what is it meant to manage?

Satyam: So I think it’s important to look at the CSA as something that allows people to manage credit risk – Credit Support Annex that is what CSA is, and therefore the primarily supported objective is to manage credit risk, manage counterparty risk and let institutions focus on the market factors that underlie the specific derivative contracts. So while I’m doing my swap I can focus on the swap terms rather than worry about the credit of the counterparty. But what’s often not fully understood is the CSA also creates a lot of implications for liquidity risk and it’s almost a balance between credit risk and liquidity risk that institutions have to set. If you create a CSA that is very safe from a counterparty risk perspective what you end up with is a CSA that puts a lot of liquidity risk and restraints and gives rise to liquidity risk.

Jockle: And now, like any derivative – you categorize a CSA as a derivative in and of itself, one of the terms we always hear about is the imperfect CSA. And I think a lot of that has to do with the imbedded optionality within that – give us a walk through.

Kancharla: So if you look at the CSA terms inside of any CSA what you will see is terms that describe the threshold at which the amounts have to be transferred. So if my exposure is more than a certain limit and there are minimum transfer amounts that are described and there’s a close out period from when the exposures are calculated, in addition there are a number of rating triggers and number of events that are embedded in the contract. And optionality in terms of the currency you can choose to post collateral. There’s also optionality in terms of whether you post cash collateral or different types of instruments that you can post. In some cases you can post securities obviously with a haircut so there are all of these choices you have to make and I think it’s the optionality embedded inside a CSA and to be honest it’s far more complicated than a typical derivative that you look at.

Jockle: Talking about the complexity, so only high rated securities are eligible to be used as collateral or different cash or by different currencies however the LIBOR scandal happened and the move between LIBOR and OIS post-2008 has created a difference in the way the risk-free rate is actually being calculated. What is the impact on the banks themselves that now have to go out and look for unsecured financing and raising that collateral?

Kancharla: Unsecured financing for the most part dried up and what we see is secured funding and the question therefore is where do institutions get all these high quality collateral that’s required as part of the contracts. And also, another issue that is closely related is rehypothication or basically the ability to use collateral from party A for supporting the needs of party B, or as collateral for another contract another transaction and that means the same dollar of cash the same Treasury bill can be used multiple times and serve as collateral for multiple contracts. While that is helpful and favorable simply because there isn’t enough cash collateral in the market it also gives rise to its own set of risks because there are scenarios where an institution might default and in spite of having very good collateral it might have too many obligations.

Jockle: Thanks you Satyam, we’ll continue this in another couple video blogs. I want to thank you. And please join the conversation follow us at @nxanalytics as well as our blogs on Numerix.com.

Thanks.

What do you think? Weigh in and continue the conversation on Twitter @nxanalytics, LinkedIn, or in the comments section below.

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