When It Comes to Sovereign CDS, Collateral is King

We have talked a lot about sovereign CDS exposures being largely collateralized. What exactly do we mean by that? And why is it so important to understand how collateral works?

Exposures between two counterparties under an ISDA Master Agreement are typically subject to one of ISDA’s credit support annexes. Our margin survey indicates that over 70% of derivatives exposure is subject to these arrangements. But some of the entities that are users of other types of derivatives ‒ sovereigns, supranationals and corporates ‒ are not active in CDS. As a result, well over 90% of CDS are subject to collateral arrangements, and these arrangements are virtually all two-way (i.e., either party could post collateral to the other based on the mark-to-market value of trades between them).

With the standardization of CDS contracts resulting from the 2009 Big Bang Protocol, there are now two standard coupons on CDS, 100 basis points for investment grade credits and 500 basis points for high yield names. An upfront payment is made by one party to the other to reflect the present value of the difference between the market rate for buying protection and the standard coupon. Where the reference entity is distressed, a significant amount is paid by the buyer of protection upfront because the market rate for buying protection greatly exceeds the coupon.

This upfront payment feature of the CDS market is distinct from other derivatives markets. But once the upfront payment is made, the collateral practice is the same. The trade is marked to market and collateral is posted. For a distressed reference entity, the protection seller would have to post collateral, but the amount of that collateral would, at least initially, be more or less equivalent to the upfront payment. In effect, the upfront payment from the buyer to the seller becomes the collateral that the seller posts with the buyer. Subsequent, incremental fluctuations in market value will lead to more collateral being posted or some collateral being returned.

To understand the implications of collateral arrangements, let’s take a simple example involving Greek CDS. Let’s assume that Bank A is a net seller of five-year protection and that all of its Greek CDS trades are with one other bank, Bank B.  In this case, Bank A would have posted collateral, primarily cash, to Bank B in an amount equal to the mark-to-market value of the CDS trades. 

As the likelihood of default increases, the value of the contract will increase as well and more collateral will need to be posted, a process that happens daily. So based upon current prices for five-year Greek CDS, Bank A will be posting 62% or so of notional against the Greek protection it has sold. Each day, assuming conditions get worse, the amount of collateral increases. The risk for Bank B is that either Bank A defaults on one of the daily incremental collateral calls or a Greek default occurs and the price of the CDS increases greatly. However, this latter event would hardly constitute an extreme “jump to default” situation, such as where an otherwise creditworthy entity defaults out of the blue, generating a collateral call of 50% or more. So Bank A’s daily collateral requirement will be relatively modest and the replacement cost to Bank B will be modest if, indeed, Bank A should default for whatever reason.

Counterparty risk management for CDS involves assessing the exposure that could arise between one counterparty and another due to a jump to default by a reference entity or a counterparty default on the CDS. How much does it cost to replace the defaulted positions as well as the shortfall in collateral? There is no unsecured exposure before the default. In Bank A’s case, it already has posted 62% against its sold Greek protection.

Collateral management between two dealers is more complex, of course, because all their OTC derivatives contracts are covered by one collateral arrangement. But the principle is the same: how much collateral was not delivered and how much will it cost to replace the positions? Collateral arrangements between dealers are also very efficient due to netting arrangements that enable in the money positions to offset out of the money positions across asset classes.

One final note: Consider what happens when, as is far more likely than not, Bank A performs its obligations under the Greek CDS. When Bank A performs its obligations on the Greek CDS the balance on its collateral arrangements with Bank B will be altered. After payment on the Greek CDS, the net mark-to-market position shifts. Because the Greek CDS trades are settled, Bank A will be able to demand collateral to be returned to it by Bank B.

Collateral is an incredibly powerful and dynamic tool and understanding how it works should, we believe, provide a great deal of comfort to both experienced and casual observers of the sovereign CDS product.

Small-user benefit amounts to small change

Last week, ISDA published a new Discussion Paper – Costs and Benefits of Mandatory Electronic Execution Requirements – which examined the implications of these mandates in the Dodd-Frank Act as interpreted by the CFTC. We believe the paper made a compelling case that these requirements would not pass a cost-benefit test, but we also stated that we look forward to the test the CFTC will no doubt produce. In this week’s derivatiViews, we’ll focus on one of the key issues in the study – the benefits to small users. After all, small users have been regularly cited as the real beneficiaries of the electronic execution mandates.

Let’s first agree on some assumptions. Small users have to be financial entities – banks, insurance companies and investment firms. Financial entities are covered by the mandatory clearing requirement as well as the electronic trading requirement. In fact, if they hadn’t been forced to clear, they wouldn’t be subject to the electronic trading requirement.

Let’s also assume a typical interest rate swap for this group is $10 million. That might seem like a large amount to some of our readers but if the average size trade is much smaller, it will be hard to see how potential benefits can amount to any worthwhile sum. Let’s also agree not to debate the issue of clearing and current pricing for interest rate swaps. Presumably, if swaps have not been collateralized in the past, dealers charged these small users for credit costs. These credit costs may, or may not, have exceeded the costs of clearing. Let’s assume that the average swap is for five years as well.

Now let’s turn to an important finding in the study. The study took pricing runs from three dealer electronic platforms. The runs were synchronized so that we receive pricing at precisely the same time – once a minute each trading day for four weeks (at a time, July 19 through August 12, when volatility had begun to spike). These platforms were designed largely for plain vanilla swaps with small users who had been pre-approved for credit. What the study showed was that the bid-offer spreads on these platforms were one-half basis point per annum or lower in most maturities with a greater than 90% confidence level. A zero bid-offer spread (which is the smallest spread possible and which is obviously impossible to achieve in practice) represents a quarter basis point improvement from a half basis point bid-offer as both sides of the market get better pricing. A quarter basis point improvement over five years has a net present value of about 1.2 basis points or 0.00012 in price terms. For a $10 million swap, that amounts to $1,200. Depending on interest rates, it might be more or less, and in our study we rounded it down to $1,000. For a $5 million swap, the improvement will be half of the amount for a $10 million swap, or $500 to $600.

It is our contention that this pricing will be available to clearing clients through dealer platforms for small plain vanilla swaps. Once a client is approved for clearing, there is absolutely no reason why these facilities will not be available to the small user. Indeed, that is the reason why the platforms were developed – to provide automatic execution for small trades. A clearing client just has to demand access to the platforms before agreeing to become a clearing client.

So the greatest possible savings is $600 or $1,200 per trade. That excludes execution costs. All the development costs of SEFs, dealers, SROs and the CFTC have to be passed along. This will likely increase costs for users. Perhaps the entry of new dealers to the market will bring down spreads? To what? Consider that the study did find that the trading costs for futures execution of swap-like strips of Eurodollar contracts was actually greater than the trading costs for interest rate swaps.

All of this gives us a funny feeling about why we haven’t seen a cost-benefit analysis from the CFTC. Particularly since it is required by law. And as we all know, when Congress passes a law, we have to follow it.

The First Rule About CDS: Don’t Talk About CDS (Unless You’ve Read the Contract)

Since the Eurozone proposal for a 50% haircut on outstanding Greek debt was issued, many pundits have questioned the value of sovereign CDS. If the contract is not triggered by that level of haircut, they opine, then the product is somehow flawed.

We suggest the pundits first read our FAQ on the subject, and then, if they are still interested, the definition of the Restructuring credit event. A simple rule to follow is that if you are going to opine on a contract, you have to read the contract. In any event, we will leave it to our well-tested determinations committee process to decide the issue, if and when a question is presented.

We do, though, think it’s important to provide some perspective on the issue. Let’s start by considering two other credit events. The first – Bankruptcy – is a standard credit event in the corporate CDS world but not in the sovereign CDS world. It has the advantage of providing a pretty bright line, typically a bankruptcy or insolvency filing. There are other events in the definition that could trigger a bankruptcy credit event short of an actual filing. It is possible that the events that have transpired regarding Greece and Greek debt might have triggered a Bankruptcy credit event if we were dealing with a corporate. But we will never know because we are not dealing with Hellenic Republic, Ltd.

The second type of credit event – Repudiation/Moratorium – does apply to a standard sovereign CDS contract. It recognizes the particular steps that a sovereign might take to disavow obligations under its indebtedness. It involves a declaration of a sovereign’s inability or unwillingness to fulfill its outstanding obligations. That’s a serious step, with implications for the country’s economy and the sovereign’s future ability to access the international debt markets, but it is not unheard of for it to occur. Russia did it in 1998. Yet no one involved in the discussions surrounding Greece wants to touch this third rail.
Without an ability to declare bankruptcy and given the reluctance to formally repudiate indebtedness, negotiators have centered on a voluntary exchange of old debt for new, with the resulting focus on the Restructuring credit event. Yes, we know that some holders of Greek debt are between a rock and a hard place. And we know that officials have put significant pressure on banks to accept the deal. It does sound a bit like someone has made them an offer they can’t refuse.

The fact remains, though, that the exchange is not binding on all debt holders. If you don’t like the deal, don’t exchange your bonds. Hold onto them. Whether you take the deal or not, you will keep your CDS. Collect the payments on the bond as long as they are being made. If a payment is missed, trigger the CDS and be made whole. Users of these products know the drill. In fact, it could be a more economic proposition for some holders of Greek bonds.

The obsession with avoiding a credit event is, in our view, misguided. (Others agree; see this WSJ blog post.) All this to avoid settlements that we know from DTCC data will not exceed $3.7 billion in the aggregate, most of which has already been collateralized.

ISDA will certainly reflect on this experience, consult with its members and consider whether future changes to its definitions are appropriate. The sovereign CDS product will no doubt continue to evolve. Evolution, often driven by external events, is typical of any derivative product. That’s a process that we have seen time and time again. And whatever the document says in the future, we hope people will read it before they opine on it.

Clearing, Compression and Customization

We at ISDA have worked hard on building the infrastructure of the OTC derivatives market. At times, it might seem we take credit for what others have done. But the funny thing about ISDA is that thousands of people think of themselves as part of the Association. One of our Board members said he counted 200 people in his firm alone who were active in ISDA committees, working groups and projects. We count all who work in the industry as part of ISDA. We represent them and like to publicize progress, regardless of which entity actually did the work – as long as it makes our markets safer and more efficient.

In that spirit, we turn to LCH SwapClear. Their focus for over 10 years has been inter-dealer clearing across many currencies, and they are actively reaching out to the buy-side to expand clearing as well as to incorporate new products. It’s a fact, not sufficiently recognized in our view, that SwapClear has cleared over 50% of the interest rate swap market. During the Lehman default in 2008, SwapClear assigned over $8 trillion of Lehman interest rate swaps and returned over half of the initial margin that was posted.

SwapClear has quietly worked at another project – compression. In this effort they work closely with TriOptima, which has a long track record of compressing cleared and non-cleared swaps. This past week, they were able to cancel nearly $26 trillion of contracts. Since this program started, SwapClear has torn up $89 trillion of contracts. TriOptima has compressed a total of $158 trillion, including $74 trillion of uncleared trades since 2003. Compression will work even better as more dealers join SwapClear and participate in the compression process. It is a great way to ensure volumes at clearinghouses do not grow excessively large.

We at ISDA will work with SwapClear, Tri-Optima and our members to promote compression. We believe it has great potential to do much more.

What else can we find out from the trades in SwapClear? They recently analyzed nearly one million trades in their clearinghouse and identified the number of instances there were five or more trades that had 10 identical terms. It sounds like a lot of terms but it’s not. Currency, start date, end date, fixed rate, index (e.g., Libor), index tenor (e.g., 3-month), day count, business day convention, holidays and roll date. Seems like a pretty standardized trade to us. Yet we were surprised to learn that less than 9% of SwapClear’s trades met this definition of standardized.

To date, SwapClear has done primarily dealer trades and dealers typically write “standardized” trades with one another. What the analysis tells us is two things. First, there just aren’t that many six-year sterling or dollar or euro swaps written in any day. If we think there might be 20 full-year maturities in the 17 currencies, that amounts to 340 possibilities alone and SwapClear clears probably around 2,000 trades a day. You do the math. Second, it seems dealers fine tune some of the terms they negotiate with other dealers. Fine tuning transactions is, of course, one of the great strengths of the OTC derivatives market. And keep in mind, these trades are all cleared, so it is not fine tuning for the sake of fine tuning.

Another interesting fact stands out in the SwapClear analysis. Over half of SwapClear’s trades are unique. So much for trading like futures.

We thought our readers would find this data interesting. We hope regulators do as well.