Dec 4, 2012

Managing the Embedded Optionality of CSAs

In this video blog, Numerix Host James Jockle, SVP of Marketing, and Satyam Kancharla, SVP of Client Solutions, explore the challenges of managing the optionality of embedded Credit Support Annex (CSAs)– including the potential valuation challenges surrounding this issue.  Jim and Satyam also discuss how organizations can optimize upon all the terms embedded in the CSA and ways to manage potential pricing challenges.


Numerix Video Blog Transcript – Managing the Optionality of Embedded CSAs

Jim Jockle (Host): Hi I’m Jim Jockle and welcome to Numerix video blog. With me again, Satyam Kancharla, SVP of Client Solutions Group

Kancharla (Guest): Hi Jim.

Jockle: Continuing our conversation, if you didn’t catch our last video blog, we talked about the ABC’s of the CSA.  Clearly we talked a little bit about the challenges related to funding, the changes in Libor/ OIS, the availability of high quality collateral especially in this environment, but today I wanted to talk about the potential valuation challenges around that, in terms of managing that optionality within the embedded CSA itself. Clearly, it’s posing more and more of a challenge for individual banks.

Kancharla: Definitely. There are valuation challenges post-execution, and there are pricing challenges pre-execution and institutions are looking to a way in which they can optimize upon all the terms that are embedded in the CSA. So what is the best way for me to deal with all of these different terms? Which counterparty should I execute with? What is the spread that I’m being charged by my counterparty? Is that the only criteria I should think about?  Or do I look at other things that are embedded in the CSA, which could come back and hurt me later when I’m ready to unwind, or later when there is a credit event perhaps, or a CSA that is going to be very stringent from a liquidity perspective?

Jockle: You know, you touch on something also very interesting. Clearly, we can see the changes in valuation, which in and of itself, we might have different books between the accounting books and how the derivatives are being valued in the back office, but also within the front office and how they are managed. So, that raises two questions for me: Price transparency. If I’m thinking about managing all the optionality within the CSA as part of my pre-trade thought process, it seems like there are a lot of areas that could go wrong.

Kancharla: Yes. There are a huge number of areas that need to be taken into account. The different curves, the different types of instruments that companies post as collateral and here is where institutions have to examine and have a very clear collateral management policy that starts at the beginning before execution, the pre-trade stage, and goes through all the way to daily collateral management.

Jockle: On the opposite side, what kind of challenges if the deal is traded in terms of the novation process, as part of an unwind?

Kancharla: There are pricing challenges both pre-trade or at unwind. Because of all the terms in the CSA, counterparties are more likely to disagree about what the fair price is. And that’s fine. From a trading perspective that is fine. It just means that the transactions are being allocated in the optimal way to take into account credit risk and liquidity risk.

The big challenge, of course, is on the unwind, and at that point the role of the valuation agent is really important, and it’s really important to clarify the valuation approaches that counterparties use, and the valuation agent that one choses. In fact, for institutions that are entering into contracts with banks, it is really advisable to understand the exact methodology that will be applied to the trade at unwind. Setting that and understanding that right at the beginning, will really help institutions understand the entire lifecycle of the transaction. And, in some cases, institutions are also agreeing to a known third-party, who is a known provider of valuations, once there is a certain level of disagreement, actually the standard ISDA CSA does not really explain in a lot of detail what to do with disputes on valuation challenges, and it’s very important to get that ironed out early on.

Jockle: Now, you mentioned the standard CSA. Clearly, there are some challenges when it comes to implementation, and we are not there yet in terms of the market itself. But, clearly, one would presume that there are going to be challenges managing, we kind of joked about in our last discussion, managing the warehouse of CSAs that were kind of ‘in the basement’ that are now in the forefront against the new standardized CSA? How are institutions thinking about the disparity between the contracts?

Kancharla: The standard CSA is an attempt by the industry bodies, ISDA in particular is taking the lead, to create a standard agreement that would serve as the basis for the large proportion of banks that deal in derivatives. Now, what’s important to realize is that the CSA is ultimately a bi-lateral contract that takes into account the particularities of those counterparties, their credit position, their liquidity position, etc. and therefore to have a one-size-fits all is also not practical. And, we will see that there will be several institutions and several cases where you have CSAs between a very highly rated counterparty and low rated counterparty, and you may have unilateral CSAs or you may have CSAs that are skewed in some way, simply because one counterparty is weaker than another, so overall, we will see more and more reduction of the standardized CSAs, particularly in the interbank market, but we will continue to see some other types of CSAs.

Jockle:  You know that comment brings me back to reading a report, post-financial crisis, in terms of the number of defaults in the market they were very very low, but where the biggest market challenge was, was dealing with the increased probability of default. How does that play into an organization’s approach in terms of collateral management and the CSA itself?

Kancharla: Exactly. That’s a very important point. It’s the probability of default, and it’s the liquidity issues that cause the biggest stresses, and therefore, as institutions think about counterparty risk when they look at CSAs, it’s very important for them to look at liquidity issues as well, and really think through the collateral issues, and really think through the collateral clauses and the credit clauses that go in the contract, because it’s very likely that the next crisis is also something that causes liquidity challenges, rather than actual defaults.

Jockle: Well, Satyam, thank you very much. One of the things that I hear kind of thematically from you is that the middle office, back office and front office are all kind of coming together, and it’s an end-to-end process, which is probably that new risk management framework.  Thank you, and please join the conversation follow us at @nxanalytics as well as our blogs on Numerix.com.

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

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