The Dos and Donts of CSAs

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					                                                                                                RISK MANAGEMENT
The Journal of Global Treasury and Financial Risk Management

 CSA ADMIN: IN HOUSE                  Risk management
Like many treasury tasks,
                                      The Dos and Don’ts of CSAs
CSA administration can be      By Anne Friberg
outsourced or done in-house Should you or shouldn’t you have credit-support annexes with your derivative counterparties?
(see box below):               Recent discussions with treasury managers esh out the main considerations.
     In-house: Minimize
and harmonize CSA terms.
To utilize fewer resources for
CSAs, rms should consider      Pending the potential elimination of OTC con-            The Goals of the CSA. Before putting a CSA
harmonizing key terms          tracts (see IT, May 2009), members across The in place, the objectives of having one should be
across all agreements, e.g.,   NeuGroup’s peer-group universe are increasingly clear. For the presenting MNC, the objective was
use the same threshold         looking to implement credit support annexes to allow continued trades with key option coun-
schedule (see main story)      (CSAs) with collateral agreements with counter- terparties, where in-the-money option positions
for every bank. Other key      parties to limit risk. For example, well over half had chewed up credit limits. In an environment of
terms to harmonize include: of the members in the two FX Managers’ Peer increased volatility, strengthening dollar and de-
   – Frequency of posting
                               Groups (FXMPG 1 & 2) either have or are in the teriorating bank ratings, the rm – which had es-
(daily, weekly, monthly);
   – Minimum transfer          process of putting in place CSAs with all or some tablished credit limits per counterparty based on
amount (required collateral    counterparties (of the others, many are still work- agency credit ratings – had several counterpar-
must reach a certain amount ing on negotiating their ISDAs, a process that has ties that would be vulnerable to exceeding their
before a payment is made);     also increased in awareness and importance in limits. This was due to a number of long-dated
   – Calculation agent (most   the last year). But as one member noted, they are hedges that were put on when the dollar was on
often the bank counterparty, not necessary across the board; “if a bank is not a weakening trend, and thus substantially in-the-
but the company has a right competitive in derivatives, there is no need for a money. The FX group’s practice of “borrowing”
to dispute the calculation).   CSA with that bank,” he said.                       from other treasury areas’ credit limits (allowable
     Outsourced: The more                                                          in the treasury policy) was growing unwieldy.
counterparties, the more
                               A CHECKLIST FOR IMPLEMENTATION                          A secondary, yet often overriding concern
it makes sense. More coun-
terparties make for more       In a presentation by an FX director from a large for many is the ability to administer the agree-
challenging admin because      MNC at a recent meeting, he explained the ment with available bandwidth, in particular
chances are they will di er    process his company has gone through to re- with regard to posting collateral. A review of
in credit strength. Rather     view and update legacy CSAs that had become the presenting company’s legacy CSAs, written
than constrain CSA usage       cumbersome to manage, which served as its for counterparties equipped for collateral man-
for admin ease, outsourcing starting point to implement CSAs with all major agement, revealed low thresholds and hence
CSA admin does not add         derivatives counterparties. In reaction, corporate high likelihood of frequent collateral exchanges
much cost while permitting     treasury practitioners exchanged views on their (i.e., the CSAs were high maintenance). Thus, a
more granular terms and
                               response to the new environment with a partic- properly structured CSA “would e ectively cap
thresholds, plus it lets trea-
sury “wash its hands of it.”   ular focus on the role of CSAs and how to make FX exposure to any single bank and minimize
(continued on next page)
                                      them work to their best advantage.              exposure volatility to an acceptable level,” the FX

       Outsourced collateral admin costs money but permits more granular management of terms and posting.

              In-house                                                                             Outsourced

              ■ Harmonized terms                                                                   ■ Individual terms
              ■ Wide margin thresholds                                                             ■ Narrower margin thresholds
              ■ Infrequent posting                                                                 ■ Frequent/daily posting

                                                                                                     Source: The NeuGroup’s FX Summit, 2009

2009    ■   Reprinted by Deutsche Bank with permission from International Treasurer

director said and summarized his company’s CSA                  than that. However, the general rule is the bank       (continued from previous page)
goals to three main points:                                     pays back the same collateral asset class as it        When outsourcing, choose
    – Protect the rm in the event a counterparty                receives. In dealing with banks, rms are advised to    a non-trading partner
      bank is downgraded.                                       scrutinize the contract: “Make sure your language      bank as the provider. To
    – Minimize the likelihood of the rm having                  is strong and bests the language of the bank,”         reduce risk, the administra-
      to post collateral.                                       said the FX director, because they will readily        tion should not be done
    – Minimize internal resources required for                  interpret any unclear terms in their own favor.        by a bank that is also one
      CSA administration.                                             Check with your auditor. Finally, before         of the company’s major
                                                                                                                       derivatives counterparties.
    Other rms noted the ability to win better pric-             signing on the dotted line of the CSA, it is im-
                                                                                                                       Treasury FX professionals
ing as their principal objective (particularly with             perative that companies speak to their auditors        note that Bank of New York
longer-dated contracts), as the CSAs mitigated                  because of the many con icting views on how            Mellon, Northern Trust and
the credit/non-performance risk now frequently                  to account for them. For instance, there is not        State Street o er good CSA
embedded in quotes received from dealers.                       any clear direction on whether collateral is to be     services; post-trade admin
      Set the posting thresholds. Part of the CSA               recognized on the balance sheet. If it’s on the        provider Misys also has a
structuring exercise is to balance downside risk                balance sheet, it could potentially become a FAS       collateral management ser-
mitigation against posting requirements. One                    157 issue. While there are few guidelines, the         vice. JPMorgan got favorable
way to set appropriate collateral posting thresh-               typical choice is between gross-up and netting.        mention but is a big trading
                                                                                                                       partner with many MNCs.
olds is to use a laddered approach; this provides                   Fortunately, another issue that arose with the
                                                                                                                       But, on the other hand,
protection in the event a bank’s credit rating gets             presenting rm’s auditors was whether a CSA             a rm using State Street
downgraded (a ratings-based approach is most                    would trigger a de-designation/re-designation          noted the custodial nature
common). However, a collateral payment is only                  event relative to FAS 133 hedges. This has been        of the relationship virtually
triggered when the mark-to-market amount hits                   resolved by an agreement between the “Big 4”           eliminated any counterparty
a predetermined $ level, for example:                           (that it would not trigger de-designation).            exposure to the bank.
    – AAA-rated counterparty: $100mm                                                                                   CSAS AND SYMMETRY
    – AA: $50mm                                                 KEEP IT SIMPLE                                         While most treasuries would
    – A: $25mm                                                  CSAs should not be entered into without consid-        like their counterparties to
    – Lower: $0                                                 ering their full rami cations. The initial instinct    post collateral, while forgo-
       Stress test the covered derivatives. A                   of many corporate treasuries implementing              ing the requirement them-
CSA is a double-edged sword in that a company                   CSAs is to structure them with an eye to ease of       selves, it is most common to
could nd itself in a position of having to post                 administration: e.g., set posting thresholds and       have bilateral and symmetri-
                                                                                                                       cal CSAs; it’s hard to negoti-
large amounts of collateral in volatile markets.                frequency so that the burden is not too great.
                                                                                                                       ate a contract that favors one
One way to help structure CSAs, or target their                 Many treasury managers even contemplate                party over the other. It is not
use, is to stress test various combinations of in-              asymmetrical requirements, with the idea that          unprecedented for a highly-
cluded instruments and types of hedges over                     banks are set up to administer credit support          rated corporate to be able to
time to determine the probability of having to                  as part of their institutional business already, so    negotiate a unilateral CSA
post collateral. The outcome could be a ected                   they won’t mind. Complicating CSAs may not be          with some banks (using the
by the instrument mix (options, forwards, etc.),                wise, however, since times change and, sudden-         threat of withdrawing busi-
for example, on the FX side, but also by including              ly, the corporate might again be the “weaker” of       ness), but it is not common.
or excluding other derivatives in the CSA, such as              the two counterparties and wish it had set up the      Asymmetrical CSAs, where
                                                                                                                       the triggers or posting
interest rate swaps. For example, purchased puts                CSA di erently (see also sidebar).
                                                                                                                       requirements are different
for cash- ow hedges can o set forward losses                        There is also the potential for OTC derivative     for the each side, are also
from balance-sheet hedges. In some scenarios                    contracts to cleared and settled via centralized       uncommon, but there are
interest-rate swaps can o set declines in option                counterparty entities and, with this, collateral       instances when asymmetry
values. But if correlations break down, a company               and margin administration. Simpler CSAs will           can make sense, for example:
can nd itself on the “losing” end of both trades.               make migration easier and may also ease quick             ■ They only cover special
       ID acceptable collateral. It is important                outsourcing to a custodial bank if needed.             transactions and not the
to determine and include in writing what is                         Finally, neither CSAs nor ISDAs should take        entire relationship with the
acceptable collateral for your rm. The language                 the place of carefully selecting the banking part-     bank/counterparty;
                                                                                                                          ■ Weaker banks have to
in some CSA templates speci es that collateral                  ners with whom to do business. One FX director
                                                                                                                       accept lower thresholds for
can only be cash. Cash is fungible; securities are              observed that his rm was only doing business           posting; and
not. But CSAs can allow for a wide spectrum of                  with banks that are “good with options or we              ■ If the CDS spreads
acceptable collateral. The key is to spell out ex-              think won’t fail.” It is also reviewing exposures to   between the company (or
actly what kind is acceptable (down to issue, rat-              relationship banks and staying away from those         company’s industry sector)
ing, tenor, etc., if it is a security). Most corporates         where it already has a sizeable exposure. CSAs         di er signi cantly from the
will go as far as T-bills, but nothing more “risky”             don’t negate the need for common sense.                bank.

2009   ■   Reprinted by Deutsche Bank with permission from International Treasurer
                                                                                                                      FX MANAGEMENT

Risk management
                                                                                                                              OPTIONS WITH
More FX-Related Risks to Consider                                                                                             HIGHER HEDGE COSTS
                                                                                                                              While higher volatility
By Anne Friberg
                                                                                                                              means options cost more,
Dire market conditions in the recent past have increased awareness for all risks associated                                   their value also increases
with FX trading and hedging.                                                                                                  with greater risks in the
                                                                                                                              FX environment, according
Until recently, the only way with FX risk was up.         exchange clearing house); or bank proprietary                       to Deutsche Bank’s
FX volatility had increased multifold since mid-          tools (like Deutsche Bank’s Autobahn®).                             FX team.
2008 and the spreads even on spot trades were                   Country risk is also on the upswing with                           Options best to ght
widening in response to counterparty fears. As            Argentina and Venezuela leading the way. Bad                        volatility. FX managers
a result, FX managers have become much more               economic conditions increase the risk of gov-                       shouldn’t automatically turn
attuned not only to FX market risk, but the array         ernment intervention like frozen bank accounts                      to forwards when higher
of risks surrounding their FX management activi-          or even expropriation (Cargill Venezuela). Mini-                    vols make options more
ties. While banks bene t from high vols and wide          mizing transactions onshore and sovereign CDS                       expensive. The reason:
spreads, they also can be responsive to custom-           (credit default swaps) can reduce the exposure.                     in times of heightened
ers by o ering lower-cost hedging strategies                    Bank default risk had a quiet few years                       volatility, the uncertainty
(see sidebar right) and educating them on the             before roaring back to the center of attention in                   surrounding both the
changing risk environment. A presentation by              2008, starting with Bear Stearns. Counterparty                      notional amount of the
                                                                                                                              underlying (and hence
Deutsche Bank’s New York-based FX team to The             credit risk mitigation is now top of mind for cor-
                                                                                                                              how much to hedge) and
NeuGroup’s Treasurers’ Group of Thirty (T30) in           porate treasurers vis-à-vis their banks. Adding
                                                                                                                              the payment by the busi-
January helped shed light on how the nancial              CSAs (credit support annexes) to ISDAs and pur-
                                                                                                                              ness counterparty (the full
crisis had upped the ante on risk awareness.              chases of bank CDS adds protection.
                                                                                                                              risk to the underlying cash
                                                                Business transaction counterparty risk,                         ow) is much higher.
BEYOND MARKET RISK                                        while the risk to a bank is top of mind, not all                       Accordingly, in a scenario
In addition to pure market risk (see also below),         FX managers are as focused on the risk of a cus-                    where the currency moves
FX managers need to pay attention to:                     tomer or supplier failing. They too may be a party                  di erently than expected
      Settlement risk stems from the timing               to an FX transaction. Traditional methods and                       or where the transaction
mismatch between payments between the two                 instruments are available to limit this exposure                    hedged does not material-
parties to a transaction. Not getting paid could          (credit limits and insurance, supply-chain nanc-                    ize, a forward will generate
trigger untold losses but can be overcome, for            ing, etc.), but there are also other ways to cover                  a bigger P&L hit than the
example, by settling trades via CLS (continuous           the FX risk with options or contract-contingent                     option premium.
link settlement); a central counterparty (e.g., an        forwards (linked to the underlying contract).                            Premium-reducing
                                                                                                                              alternatives. While ght-
                                                                                                                              ing o volatile market
                   FINANCIAL CRISIS EXACERBATES FX REL ATED RISKS                                                             conditions with an option
                                                                                                                              is best, not every FX man-
                                                                                                                              ager can pay the premium.
                                                                                              BANK DEFAULT RISK               For them, Deutsche Bank
                                                                                                                              recommended a delta
 Cause: Timing mismatch between                                                         Cause: Insolvency                     replication strategy or an
 payment to and receipt from                                                            Risk: Default when bank owes you      option-in-arrears contract.
 counterparty                                                                           money on positions (positive MTM         In the former, an FX man-
                                                     FX RISK                            on your hedges)
 Risk: Counterparty may not pay                                                                                               ager replicates the delta
                                                                                        Solution: Collateral (CSA), credit-   of an ATMF option using
 Solution: e.g., CLS, Autobahn®                                                         protected hedge, bank CDS
                                                                                                                              on-market forwards and a
                                                                                                                              contract for di erence.
                                                                                            BUSINESS TRANSACTION                 In the latter, the option
                                                                                             COUNTERPARTY RISK                premium is a function of
                                                  MARKET RISK                                                                 realized volatility over the
 Cause: Government (excl. Central                                                       Cause: Business partner ceases to
                                                                                        exist                                 life of the trade and not
 Bank) intervention
                                         Cause: Volatility in FX rates                  Risk: Business distress and losses    implied volatility; thus, the
 Risk: War, frozen accounts, sovereign
                                         Risk: Losses from adverse                      from overhedging exposures that       premium is limited to a
 default                                 movements in FX                                have gone away                        given level should actual
 Solution: Sovereign CDS, ISDA,          Solution: FX hedges, incl. option              Solution: Options, contract-          volatility be high over the
 offshore transactions and hedging       strategies                                     contingent forwards
                                                                                                                              life of the trade.

Source: Deutsche Bank
                                                                             Reprinted by Deutsche Bank with permission from International Treasurer   ■   2009

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