This post will talk about difference between a two-way and one-way CSA agreement and describe how collateral parameters can be linked to credit quality.
Let’s briefly go through what is a CSA agreement.
CSA agreements often use in derivatives trading. A credit support annex (CSA) is a document that defines the terms for the provision of collateral by the parties in derivatives transactions. For more details, check this out.
It’s one of the four standard contact developed by ISDA (International Swap and Derivatives Association).
There may be instances when CSAs are not used. Institutions may be unable or unwilling to post collateral. This may be because their credit quality is far superior to their counterparty or they cannot commit to the operational and liquidity requirements that arise from committing to a CSA.
A two-way CSA is often established when two counterparties are relatively similar, as it will be beneficial to both parties involved. It is important to note that the two sides may not be treated equally in certain parameters, like threshold and initial margin depending on the respective risk levels of each party.
A one-way CSA differs from a two-way CSA in that the former only requires that one counterparty post collateral (either immediately or after a specific event, such as a ratings downgrade). As a result, the CSA will be beneficial to the receiver of the collateral and at the same time will present additional risk for the counterparty posting the collateral. These types of CSAs are established when two counterparties are significantly different in size, risk levels, etc.
Benefits and Risks of CSAs
The terms of a collateral agreement are usually linked to the credit quality of the counterparties in a transaction. This is beneficial when a counterpartys credit quality is strong because it minimizes operational workload. However, it is also beneficial when a counterpartys credit quality is weak as it allows the other party to enforce collateralization terms triggered by a quality downgrade.
Although credit ratings are the most common quality linked, others include market value of equity, net asset value, and traded credit spread. The benefits of linking to credit ratings must be weighed against the costs associated with the requirement of collateral when a ratings downgrade occurs.