Tuesday 27 August 2013

The ISDA 2013 Standard Credit Support Annex

On 7th June 2013 ISDA published the 2013 Standard Credit Support Annex (“SCSA”) for English and New York law forms.

It took ISDA members 4 years to finalise these forms.

The term “standard” in the SCSA means standardisation of terms NOT that it is the market standard CSA document.

ISDA expects that the SCSA will be published in several different editions over time since evolving regulatory developments might entail changes to it. The current edition is, of course, the 2013 one.

Need for the SCSA

Historically collateral documents often offered a range of eligible credit support - mainly cash in major currencies and G7 government bonds. This gave collateral givers the option to deliver from a range of collateral types.

However, many disputes arose over trade valuation where the currency of the collateral posted was different to that of the underlying swap leading to both traders valuing the swap differently.

So if an OTC derivative was denominated in US Dollars and Euro cash was offered as collateral this created a mismatch between the derivative’s funding currency and the currency of the cash collateral.

Moving to an SCSA will remove this issue for banks because they will be posting collateral in the currency of the underlying trade.

ISDA therefore believes the SCSA simplifies market processes for collateralisation by promoting consistent and transparent valuations and making assignment and risk transfer in the bilateral and cleared space more efficient. Indeed it eases risk transfer both bilaterally and with the clearing market. It removes the embedded optionality in the CSA and replaces it with standard terms under the SCSA which helps standardise valuations across the market as all parties are using the same calculations to determine the value of collateral.

The SCSA removes the option in the existing CSAs for parties to transfer collateral in the form of cash in various currencies or agreed securities or substitute that collateral with consent (a normal requirement of the English Law CSA). Normally collateral givers would provide cheapest to deliver collateral to their counterparties. This, of course, contributed to a mismatch between the derivative’s funding currency and the currency of the cash collateral.

The SCSA also promotes the adoption of overnight index swap (“OIS”) discounting. This aligns the mechanics and economics of collateralisation between the bilateral and cleared OTC derivative markets.

Finally it seeks to create a homogeneous valuation framework so as to reduce the current fuss and challenges in resolving novation and valuation disputes. By adopting OIS discounting the market is moving away from LIBOR which was previously used in OTC derivatives valuations and which diverged dramatically in 2008. A key reason for using OIS is that non-cash collateral does not align with OIS discounting but cash does.

A key feature of the SCSA is that variation margin can only be cash although initial margin (Independent Amounts) can still be non-cash collateral e.g. government bonds or corporate bonds.

Therefore the SCSA retains the operational mechanics of the current CSAs but amends the collateral calculation methodology so that derivative risk exposures and offsetting collateral are grouped into like currencies, or “silos”. Each currency silo is evaluated independently to generate the required movement of collateral in the relevant currency.

There are 17 currency silos viz:

  • Australian Dollars (AUD)
  • Canadian Dollars (CAD)
  • Swiss Francs (CHF)
  • Czech Koruna (CZK)
  • Danish Kroner (DKK)
  • Euro (EUR)
  • Pounds Sterling (GBP)
  • Hong Kong Dollars (HKD)
  • Hungarian Forint (HUF)
  • Japanese Yen (JPY)
  • Norwegian Kroner (NOK)
  • New Zealand Dollars (NZD)
  • Polish Zloty (PLN)
  • Swedish Kroner (SEK)
  • Singapore Dollars (SGD)
  • US Dollars (USD)
  • South African Rand (ZAR)

These are the same currencies in which LCH clears.

They are grouped into the 17 silos. Collateral, as mentioned above, will be posted in the currency of the underlying swap (e.g. a EUR denominated trade would have EUR cash collateral). Any non-G17 currencies will fall either into the USD or Euro buckets depending upon historical association with those currencies. Any multicurrency deals fall into the USD bucket even if the trade is not denominated in USD.  So a GBP/EUR cross currency swap would still fall into the USD silo rather than either the GBP or EUR one.  

The G17 currency silos are evaluated separately to determine the necessary collateral for each of them. However, the SCSA does not allow individual silo by silo settlement because that would create cross-currency settlement risk where one party might pay their counterparty for the AUD silo early in the day but then wait to receive USD later in the day which if they did not arrive could create significant loss. This is similar to what happened in the FX market to the German Herstatt Bank in 1974 which received Deutschemarks to settle one leg of an FX deal and then went into liquidation and failed to deliver USD for the second leg later that same day. Banks incurred some USD 620 million of losses in this case.

Herstatt risk is avoided under the SCSA by a net settlement process.

On each Local Business Day all collateral flows are consolidated into a single net settlement amount. This is exactly the same as under the English Law CSA. However, to avoid funding mismatches the SCSA uses OIS rates to convert the single net settlement amount into specific currency silo amounts.

Each silo currency has an undisputed amount and the net settlement currency is called the Transport Currency and has to be a G7 currency. The Transport Currency is decided by the net deliverer of currencies across all silos.

The collateral receiver does not have to do anything with the cash collateral except pay interest at OIS for each silo undisputed amount. However, there is no restriction on reuse of collateral. It can be reused.

To ensure that the mechanics of this works for accounting purposes and takes account of accrued interest and partial returns of collateral, the Implied Swap Adjustment (“ISA”) methodology is used. This methodology is supported by a mandatory SCSA rate (the Bloomberg-ISDA SCSA fixing) set and published by Bloomberg on its screens on behalf of ISDA. This rate can then be used by market players to determine collateral and margin requirements between counterparties across multiple currencies.

The SCSA therefore offers a new alternative to the existing CSAs but it does not replace them. ISDA foresees that they will co-exist with each other with legacy trades under the CSA and new trades covered by the SCSA. There is no current compulsion to move to the SCSA. Indeed market players can move towards doing so at their own pace.  However, this may, in future, be determined by regulation implementation timelines.

It is possible to transfer deals from a CSA to the SCSA but not vice versa. This is because SCSA trades which are all cash collateralised are covered by the SCSA valuation process (OIS plus ISA) which would not work properly if such trades were transferred to a CSA. CSA trades collateralised by bonds will remain where they are.

ISDA has provided a very short Paragraph 11 template in the SCSA. This is deliberate to keep it as standardised as possible. ISDA strongly recommends that parties enter into the SCSA as it is and not seek to amend it especially as regards the valuation provisions. Certain things are standard for each party e.g. zero Thresholds and Minimum Transfer Amounts for variation margin and a Minimum Transfer Amount of USD 100,000 or Base Currency Equivalent for initial margin.  There is no Rounding under the SCSA.

ISDA has commissioned legal opinions for the SCSA from lawyers in England and Wales, New York and Germany. ISDA will arrange for the collateral opinions to be updated for the SCSA in other countries where they have commissioned opinions.

So parties might decide to use the SCSA for the following reasons:

  • To eliminate the collateral optionality present in so many existing CSAs.
  • Trade valuation is more consistent and transparent under the SCSA because calculations are simplified by standardising terms.
  • With variation margin limited to cash collateral, funding costs and collateral valuation are aligned in the same currency.
  • This avoids margin disputes.
  • The SCSA valuation methodology dovetails with that used in clearing houses.
  • Novations and assignments to CCPs are easier.
  • With amendments discouraged, any negotiation time should be considerably reduced.

Of course, market players will need to have the right operating systems to achieve these goals and the costs of this may make take up of the SCSA a rather slow process in some cases.

Paul C. Harding

© Derivatives Documentation Limited

Posted by Paul Harding

Category: Standard Credit Support Annex

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