LO 26.2: Describe the terms o f a collateral agreement and features o f a credit support annex (CSA) within the ISD A M aster Agreement including threshold, initial margin, m inim um transfer am ount and rounding, haircuts, credit quality, and credit support amount.
The concept behind collateralization is straightforward. When two parties execute certain trades (e.g., OTC forwards, swaps), one will have a negative MtM (mark-to-market) exposure, and the other party will have a positive MtM exposure at any given time. The party with the negative exposure will then post collateral in the form of cash or securities to the party with the positive exposure. In essence, collateral is an asset supporting a risk in a legally enforceable way. Collateral management is often bilateral, where either side to a transaction is required to post or return collateral to the side with the positive exposure.
Firms can manage credit exposures and mitigate counterparty credit risk by either limiting the notional value of trades with counterparties or offsetting trades that limit exposure though netting. There are essentially four motivations for managing collateral: (1) reduce credit exposure to enable more trading, (2) have the ability to trade with a counterparty (e.g., restrictions on credit ratings may preclude an entity from trading on an uncollateralized basis), (3) reduce capital requirements, and (4) allow for more competitive pricing of counterparty risk.
Collateral management has evolved over the last few decades from having no legal standards to being highly standardized through the introduction of ISDA documentation in 1994. The purpose of a credit support annex (CSA) incorporated into an ISDA Master Agreement is to allow the parties to the agreement to mitigate credit risk through the posting of collateral. Because collateral can vary greatly in terms of amount, liquidity, and risk levels (as well as many other elements), a CSA is created to govern issues such as
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Topic 26 Cross Reference to GARP Assigned Reading – Gregory, Chapter 6
collateral eligibility, interest rate payments, timing and mechanics associated with transfers, posted collateral calculations, haircuts to collateral securities (if applicable), substitutions of collateral, timing and methods for valuation, reuse of collateral, handling disputes, and collateral changes that may be triggered by various events. In order to work as intended, CSAs must define all collateralization parameters and account for any scenarios that may impact both the counterparties and the collateral they are posting.
Parameters established with CSAs (and collateralized agreements in general) include the following:
Threshold: Collateral will be posted when the level of MtM exposure exceeds this
threshold level. Initial margin (also known as independent amount in bilateral markets): The amount of extra collateral that is required independent of the level of exposure.
Minimum transfer amount: The minimum amount of collateral that can be called at a
given time.
Rounding: Collateral calls or collateral returns may be rounded to specific sizes to avoid
working with inconvenient quantities.
Haircut: This reduces the value of collateral to account for the possibility that its price
may fall between the previous collateral call and a counterparty default.
Credit quality: As counterparty credit quality declines, the importance of collateral
increases.
Credit support amount: The amount of collateral that may be called (by either
counterparty) at a certain point in time.
Professors Note: The terms o f a collateral agreement as well as descriptions of threshold, initial margin, minimum transfer amount, rounding, haircuts, and credit quality will be addressed in LO 2 6 .6 when we explain the features o f a collateralization agreement.
V a l u a t i o n A g e n t s