Credit Support Annex And OTC Pricing
Since the financial crisis, banks are charging customers credit charges if the customer did not conclude a Credit Support Annex (CSA) with the bank. In this article we are making an analysis on this subject matter.
What is a Credit Support Annex (CSA)?
A Credit Support Annex (CSA) is an agreement which regulates and defines the credit support (collateral) for OTC derivative transactions like swaps. A CSA mitigates the credit risk arising from in-the-money positions by defining the terms and conditions under which collateral is posted/transferred between the counterparties of the swap transaction. These terms and conditions mainly specify parameters like:
- Threshold Amount: This amount is the reference value of the mark-to-market of the swap above which collateral has to be posted. For example, if the Threshold Amount is €5.0 mln for a party, this party is required to post collateral only when the negative mark-to-market of the swap is above €5.0 mln.
- Frequency: Both parties need to agree on the frequency of collateral postings. Often applied frequencies are daily, weekly, and bi-weekly, meaning collateral transfers can only take place every day, weekly, or bi-weekly respectively.
- Eligible Collateral: The assets that classify as eligible collateral need to be negotiated. Cash and government bonds are the most common eligible instruments. If securities are to be used, it is necessary to define a set of eligible instruments along with the associated haircuts.
- Minimum Transfer Amount: If the difference between the mark-to-market and the value of the collateral position is in excess of the Minimum Transfer Amount (MTA), extra collateral needs to be posted. The MTA provides operational efficiency as it prevents from small amounts to be paid/received.
A Corporate has entered into a 10yr EUR/USD cross-currency swap with a bank, whereby the bank pays a fixed USD coupon and the Corporate pays a fixed EUR coupon. The swap is documented under a CSA with the following terms and conditions:
- Threshold Amount: €5.0 mln
- Frequency: weekly
- Eligible Collateral: EUR cash only
- Minimum Transfer Amount: €1.0 mln
- On day 1 the mark-to-market of the swap is zero, but after two weeks the mark-to-market moves to +€6.5 mln from the bank’s perspective (i.e. ITM for the bank by €6.5 mln). The mark-to-market is above the Threshold Amount, so a collateral amount equal to €1.5 mln needs to be posted by the Corporate.
After three weeks the mark-to-market increases to €7.0 mln.
- As the change in mark-to-market (€0.5 mln) is smaller than the Minimum Transfer Amount (€1.0 mln), no additional collateral needs to be posted.
A CSA changes the market-to-market profile of a swap as it lowers the expected exposure and mitigates credit risk/charges.
To illustrate the effect of entering into a swap transaction subject to a CSA, we analyse the difference in credit charges by the bank between entering into an €10.0 mln interest rate swap with/without CSA for a BBB+ rated company:
|5 year IRS
||0,20 bps (= € 1.000,-)
||0,90 bps (= € 4.500,-)
|7 year IRS
||0,30 bps (= € 2.100,-)
||1,80 bps (= € 12.600,-)
|10 year IRS
||0,40 bps (= € 4.000,-)
||3,50 bps (= € 35.000,-)
- When the bank enters into a swap transaction with a Corporate, the bank could hedge the swap in the market by entering into a back-to-back swap transaction with a collateralised market counterparty.
- If the swap mark-to-market goes into the Corporate’s favour, the bank’s swap with the market counterparty moves into the bank’s favour. The bank does not post any collateral to the Corporate, but receives collateral from the market counterparty i.e. the bank receives (free) funding equal to the mark-to-market position.
- If the mark-to-market moves in the opposite direction, the Corporate will fund the mark-to-market position of the bank with the market counterparty.
The bank’s funding mismatch results in funding benefits and charges impacting the pricing of a swap.
Impact of funding mismatch when a swap is not subject to a CSA
- Depending on the mark-to-market of the swap with the corporate, the bank either receives funding or has to fund itself, which results in funding benefits or charges respectively.
- In the past funding benefits and charges were neglectable as banks would receive funding as well fund themselves at Libor.
- However, given the more recent liquidity squeeze, it has become difficult for many banks to fund themselves at Libor and financing needs to be sourced from either the Central Bank or the market at significantly higher levels.
- As a result, funding benefits and charges have started to impact the pricing of derivatives like swaps
Impact on swap pricing from the bank’s perspective
- The funding mismatch mainly affects off-market transactions and funding trades. Under this type of transactions the bank incurs a funding charge on day 1 (upfront funding charge), which it includes in the swap pricing.
- However, even for “simple” cross-currency swaps that do not incur an upfront funding charge, banks do also consider potential future funding benefits/charges.
To illustrate, assume the rather extreme example of a €/¥ cross-currency swap whereby the bank pays a low ¥ coupon and receives a higher € coupon.
- The mark-to-market position is expected to go into the client’s favour, which means the bank receives funding equal to the mark-to-market position
- Practically speaking, from the bank’s perspective, the swap can be considered a series of small “funding transactions” and when multiplied with the bank’s credit spread, creates a “funding benefit”.
The implicit funding benefit does not impact the upfront pricing of the swap, but is considered a “windfall gain” that will only become relevant if the bank decides to book the funding benefit as upfront profit on the transaction. In this case:
- The funding benefit will show up as an immediate reduction in the mark-to-market valuation of the swap from the client’s point of view
- In case of an early unwind of the swap, the bank might try to charge the client an amount equal to the funding benefit in order to avoid booking a loss
- In case you want to conclude a CSA with your banking counterparts, mind that this will have a financing aspect on your outstanding OTC hedges. The CSA increases the cost of hedging and the CSA will increase your funding needs.
- In case you do not conclude a CSA with your banking counterparts, the cost of hedging increases because of the credit charges (approximately 3,5 bps for 10 year swaps for a BBB+ rated company).
- This makes futures traded on an exchange increasingly more interesting than OTC hedges. For futures positions you will need to exchange margin call, which is equivalent to collateral for OTC hedges. However, with futures your counterparty will be the Clearing with a solvency ratio of 100 %; banks have a solvency ratio of maximum 10 %. And, futures are traded with a much sharper bid offer spreads than OTC hedges.
- Be aware that your banks also pay out collateral to you in case the mark-to-market of the hedges moves in your favour. Do not accept “windfall gain” situations on the banking side, but apply the same definitions to your financial counterparts. Mind that your banking counterparts have a solvency that is much worse than yours; we have all experienced where this can end up into.
- The arguments in the example above for the €/¥ cross-currency swap are not correct. Interest differentials do not say anything about funding costs. Future ¥ coupons can be sold in the FX forward market against a premium, which is offsetting the interest rate differentials between € and ¥.