Let’s rewind back to 2008. OTC derivative transactions were routinely discounted using Libor, while collateral was actually funded at an overnight rate. At that time there was no issue with doing this as the spread between Libor and OIS was negligible. As we now know, this didn’t remain the case.
Some dealers switched to discounting using the interest rate paid on the assets collateralising the trades. By using their more advanced multi-curve valuation models, they could more accurately price trades enabling them to identify opportunities to rebalance their exposures.
Why is this history relevant right now? With the VM regulation deadline of March 2017 looming, the OTC derivative market is about to go through a widespread CSA repapering process. Some estimates suggest that around 200,000 CSAs will need to be amended in order to comply with the bilateral margin rules set by BCBS/IOSCO, with many individual buy-side firms having many 100’s of CSAs in place.
Amending CSA terms on an existing agreement can have a significant impact on the value of a portfolio (just as voluntary clearing at a clearing house would do). Consequently, this triggers the need to agree on a potential payment between the dealer and client or vice versa for every individual CSA.
This all comes at a time when dealers are facing pressure on their ROEs due to regulatory changes such as leverage ratio and NSFR. They are increasingly keen for the buy-side to exchange cash collateral in the currency of the underlying exposures, on a daily basis. A key driver for the dealers is that only daily-exchanged cash-settled VM can provide them with capital relief.
On the other hand, many funds would like to keep their ability to post other assets. Pension funds, for instance, tend to be fully allocated and do not hold cash reserves within their funds. Contraction of repo liquidity (also impacted by regulation) has closed down the ability for buy-side firms to raise cash using the securities held in their funds. Many buy-side firms are worried that moving to single-currency cash CSAs might not be such a good idea. They are now faced with having to make some key strategic decisions with regards to the potential asset-allocation implications of needing to hold more cash in their funds to meet margin requirements in periods of market stress.
Many buy-side firms will be entering these discussions with their dealers without the ability to independently price the impact of the CSA changes on their book. It is therefore impossible to know the value of the CSA optionality that they may be giving up.
OpenGamma’s award-winning derivatives analytics are currently being used by our buy-side customers to allow them to independently price their derivative positions, for example using different CSA assumptions. We are seeing an increased level of interest in our solutions as firms prepare for their upcoming negotiations.