Industry Push On for Collateral Standards

Terry Flanagan

ISDA’s Standard Credit Support Annex aims to align the processes for bilateral and cleared derivatives.

Efforts to standardize the way collateral is calculated have subsumed many other issues associated with the move to central clearing.

“The challenge with derivatives is that the trade sizes can be very large,” Robin Strong, director of buy side market strategy at Fidessa, told Markets Media. “They’re margin products, so the exposure can be quite significant relative to the capital base. You do have some long running exposure.”

A milestone of sorts has been achieved with the International Swaps and Derivatives Association’s (ISDA) launch of a standard credit support annex (SCSA).

A credit support annex is an agreement to an OTC derivatives contract that governs the calculation of collateral. In technical terms, “a CSA is a complex derivative on a portfolio of underlying derivatives, with contingent daily flows of collateral and embedded exotic options,” according to ISDA.

The SCSA seeks to standardize market practices by removing “embedded optionality” in the existing CSA.

Tremendous optionality exists in CSAs, according to a presentation by ISDA. There could literally be millions of denominations of terms.

The SCSA also seeks to promote the adoption of overnight index swap discounting for derivatives.

An overnight indexed swap (OIS) is an interest rate swap where the periodic floating rate of the swap is equal to the geometric average of an overnight index (i.e., a published interest rate which is also called Overnight Rate) over every day of the payment period. The index is typically an interest rate considered less risky than the corresponding interbank rate (LIBOR).

In the United States, OIS rates are calculated by reference to daily federal funds rate.

The credit crunch of 2008 highlighted the need for valuation methodologies to account for the nature of collateral that applies to OTC transactions covered by a credit support annex, according tot a report by BNP Paribas.

Discounting methodologies that take into account OIS spreads—that is, the difference between OIS rates and LIBOR—are increasingly popular and are progressively replacing LIBOR-based methodologies, BNP Paribas noted.

CCPs, notably LCH.Clearnet, are moving to OIS discounting methodologies in their swap-clearing activities.

Since 2010, LCH has been using the (OIS) rate curves to discount its interest-rate swaps portfolio in its SwapClear IRS service.

Previously, in line with market practice, the portfolio was discounted using LIBOR.  However, an increasing proportion of trades are now priced using OIS discounting.  LCH.Clearnet decided to move to OIS to ensure the most accurate valuation of its portfolio for risk management purposes.

The SCSA supports the move to OIS discounting by grouping derivatives into separate buckets or “silos,” based on currency. Each currency silo is evaluated independently to generate a required movement of collateral in the relevant currency.

This aligns bilateral collateral structures to be more consistent with the LCH and other CCPs that adopt consistent margin approaches, ISDA said.

An OIS-based standard CSA substantially consistent with the LCH would facilitate the novation of OTC derivatives to CCPs, according to the ISDA presentation.

The SCSA has been under development since July 2010, when the ISDA Board agreed to investigate the feasibility of an SCSA.

In May 2011, the Collateral Steering Committee delivered a feasibility study (“The Standard Credit Support Annex”).

Subsequently, the Board charged the Committee to develop and implementation pan for the SCSA, addressing the practical and logistical aspects of expeditiously bringing the SCSA to market.

ISDA has discussed the SCSA with the NY Fed, the CFTC, the UK FSA, the Bank of England, and the OTC Derivatives Supervisors Group. There is recognition that the SCSA is structurally important to the market, and that proposed industry practice change such as SCSA and regulatory change are consistent.

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