The enforcement of Daily Variation Margin (VM) exchange on uncleared derivatives for the majority of counterparties comes into effect within five months. With the March 2017 deadline fast approaching in the US, Canada, and Japan and a number of market participants’ current CSAs being non-compliant (in terms of the March rules), the industry has embarked on a wide-scale CSA renegotiation process. The importance of this cannot be overstated.
Negotiating each agreement can be lengthy and, with timing a real and harsh constraint, dealers are keen to have clients sign new standardised CSAs so trading can carry on as usual. But making the right decision is no easy task for the buy-side; it is vital they do so as it can impact the value of portfolios by millions of pounds sterling.
There are three options:
- Sign the new standardised CSA on offer, which may have reduced optionality (compared to their current agreements)
- Amend their current CSA
- Take the “replicate-and-amend” approach (where existing CSAs are replicated and amended to comply with the rules)
So which approach is best?
The first step in the process is to compare the value of portfolios with the economic impact that amending collateral terms in a CSA will have. You may be shocked.
In our analysis, we’ve assumed that a typical book is made up of the following types of trades:
- Vanilla Interest Rate Swaps
- Zero-coupon Swaps
- Inflation Swaps
- Cross-currency Swaps
- Swaptions
We valued them under various CSA terms (detailed later), using trades across the three main currencies: GBP, USD, EUR. So what were the key takeaways?
- The impact of changing from a multi-currency to a single-currency cash CSA on a single vanilla swap deal with 30 years remaining maturity was equivalent to 10% of the notional value.
- Incorrectly valuing cross-currency swaps by not factoring in the cross-currency basis under a single or multi-currency cash CSAs can lead to a 35bps spread on a single deal.
Now let’s get into the meat of the problem.
To quantify the impact that CSA terms have on a typical portfolio, we have made some additional assumptions: that exposures are directional, with trades having significant notionals.
We quantified the impact of collateral eligibility on PV, with 2 common CSA types:
- A single-currency (USD in our example) or siloed CSA (CSA1), where each trade exposure is collateralised in cash in the underlying currency of the trade. This results in each trade being valued using OIS discounting in the currency of the trade. For GBP/USD cross-currency swaps, each trade exposure is collateralised in USD cash.
- A multi-currency CSA (CSA2), where GBP, USD and EUR cash are eligible. Trades are discounted based on the Cheapest-to-Deliver currency.
The Impact
Firstly, let’s take a look at a Vanilla Interest Rate Swap for example, a standard 100m 40Y USD Libor 3M IRS maturing in 30 years. The PVs for this swap under the various CSA terms described are given in Table 1. As you can see the terms of the CSA dictate the valuation of the swap:
CSA Type |
CSA1 Single Ccy |
CSA2 Multi Ccy |
Trade PV |
£85m |
£75m |
Table 1: Valuation of a 40Y USD LIBOR 3M IRS with 30Y remaining maturity under different CSA terms
If we assume that the current discounting method to date has been Libor discounting, the valuations differences to Libor discounting are:
CSA / Valuation Type |
Libor disc. |
CSA1 Single Ccy |
CSA2 Multi Ccy |
Trade PV |
£80m |
£5m |
£-5m |
Table 2: Valuation of a 40Y USD LIBOR 3M IRS with 30Y remaining maturity using Libor discounting and under different CSA terms
The difference in values between CSA1 and CSA2 is very interesting, as it quantifies the valuation impact of switching from a multi-currency cash CSA to a single-currency cash CSA (or vice-versa) – in our example, this difference is £10m, or 10% of the trade notional.
Why such a difference? It’s down to the fact that a multi-currency CSA will typically assume a ‘Cheapest-to-Deliver’ approach to collateral selection and therefore discounting. At current market levels, the trade cash flows are discounted using EUR EONIA, translated to the trade currency through cross-currency swaps.
Can the same be said for other OTC products? To answer this question, we turn to cross-currency swaps. Changing the CSA terms for a £100m 30Y GBP / USD cross-currency swap with 20 years remaining maturity yielded the following results:
CSA / Valuation Type |
CSA1 |
CSA2 CTD disc. |
Valuation |
Trade PV |
£-49m |
£-42m |
£-56m |
Table 3: Valuation of a 30Y GBP/USD CCS with 20Y remaining maturity under different CSA terms and valuation approaches
CSA1 and CSA2 valuations factor in the cross-currency basis – the impact of switching from a multi-currency cash CSA to a single-currency cash CSA (or vice-versa) is £7m, or 7% of the trade notional.
Under the valuation approach without the cross-currency basis, the OIS discounting for each of the legs has to be done independently, resulting in a significant PV difference (7% of notional). This is equivalent to a significant spread on the trade: 35 bps in this example.
So to answer the previous question, representative products found in a typical LDI portfolio are affected by changing the terms in a CSA. In particular, they are all significantly affected by switching from a multi-currency CSA to a single-currency CSA.
Correctly valuing cross-currency instruments is also critical: the reflection of the cross-currency basis can add up to a difference in mark-to-market in the tens of millions.
Time to take action
You may be sitting there thinking, “Well my CSAs are clean: mostly cash and some with gilts, so none of this applies to me.” Unfortunately, you would be wrong. As we showed earlier, differences in discounting between a single- and multi-curve framework have a significant impact on the valuation of the portfolio. This applies for future trades as well as current trades. Correctly valuing these instruments by factoring in the impact of collateral terms has the following benefits for asset managers:
- better pricing, by being able to independently check the dealer quote at the time of execution
- more accurate NAV reported to investors
- daily validation against dealers’ marks for collateral exchange
OpenGamma’s independent valuation service is based on our award-winning analytics and can help value your portfolio based on client mandates and CSA terms, by assigning valuation methodologies to each fund and counterparty.
For more information about our solutions, please contact Maxime Jeanniard du Dot at max@opengamma.com.