In times when banks are facing balance sheet pressure and rating downgrades, it seems sensible for their clients to review the Credit Support Annex (“CSA”) terms under which they have entered into (or are looking to enter into) interest rate swaps with such bank counterparties. This is the main protection for a swap counterparty against counterparty credit risk so it is important that the terms actually address the current state of play.
In the past, when the banks were seen as almost indestructible, it was not unusual for the CSA to be completely absent or one-sided, relieving the banks of the need to post collateral, eliminating their funding risk or shifting it entirely onto the other swap party in the case of a one-sided CSA.
Having witnessed the difficulties that highly rated banks can run into – in some cases without any warning – and the impact it can have on their swap positions, clients should again consider the credit risks that they face in terms of what they can, and should, do to protect themselves when negotiating the swap terms. The unsecured thresholds, Minimum Transfer Amounts as well as types of, and haircuts on, Eligible Credit Support are all tools to fine-tune each party’s perception of counterparty risk. And whilst ultimately the collateral terms represent a commercial decision – which also takes into account factors such as the strength of the bank relationship and availability of collateral – clients should ensure that the CSA terms reflect the bank counterparty credit risk relevant today and not, say, five years ago.
It is also important that clients use all assets at their disposal to achieve more favourable credit terms when trading with banks. For example, charging property to a bank counterparty (where possible) is a valuable method of reducing possible margin calls and hence freeing up cash that otherwise may need to be posted as collateral. Whilst property cannot be used as Eligible Credit Support (as it is not transferred to the counterparty outright (like cash or gilts) but is charged by way of an allocation through a security trust or directly (less common)), the terms of the CSA can be amended so that the net value (i.e. after agreed haircuts) of the property charged is taken into account when calculating such margin calls.
This approach is not without its problems. Firstly, would a bank counterparty be happy, from the credit perspective, to accept property as security from a client? Secondly, does the client have enough unencumbered property available to charge to make this exercise worthwhile? What haircut would be required? What type of property would be acceptable? What will happen if the client counterparty defaults and the bank needs to realise its security?
Incoming regulation is undoubtedly going to shake up the derivatives market for all involved. The new clearing obligations on all “financial counterparties” will somewhat alleviate the counterparty risk concerns but will in turn raise new ones, such as the quality of collateral that CCPs will be willing to accept. The goal posts for “non-financial counterparties” are still moving but it is likely that genuine commercial hedging will still be bilaterally negotiated and so the ways of addressing counterparty risk will be as relevant as ever, meaning that using property as collateral against swap exposures may still remain a viable option in the centrally cleared world.