IFR recently published an interesting article on inconsistencies in valuing collateral held against CDS contracts, “DERIVATIVES: Collateral muddies CDS valuation”, written by Christopher Whittall. It’s a problem that is not limited to just CDS and one we’ve heard dealers and investment managers alike gripe about.
From the article,
- “Although CDS contracts tend to be denominated in a specified currency such as US dollars, credit support annexes (which dictate the terms of collateral exchanges between swaps counterparties) often allow various major currencies to be posted, causing these valuation headaches.”
- “European sovereign CDS tends to be priced in dollars, for instance, but CSAs might allow counterparties to post less valuable currencies (such as euros) to one another. This should theoretically alter the price of the contract materially – not least because of the correlation between the value of the euro and European sovereigns – but it appears few banks fully price in these risks.”
- “’It is the first time in history that, depending on the counterparty, you don’t value your derivatives the same way,’ said the global head of credit trading at a European bank. ‘Whether you post euros, dollars or other currencies can affect the value you have on any derivative materially.’”
One investment manager told us about how they might try to sell a basket of swaps, putting the package out to bid with several dealers. Since the transaction won’t necessarily be with the dealer who originally wrote the deals (and will involve novation to the winning bidder) knowing what the CSAs between the potential counterparts allow becomes important when figuring what to bid on the package. It is somewhat analogous to evaluating the “cheapest to deliver” collateral option. Since CSAs are highly negotiated and hence not homogeneous across the industry, the value of any given swap could vary for each dealer. Differing CSA agreements add another layer of moving parts. It is ironic that the market might clear based on an agreement that the investment manager is not even party to.
Dealers would like some sort of consistency in collateral. But it is easier said than done. A European dealer might want to give Euros and avoid US$ funding risk. A U.S. dealer might be the exact opposite.
Once these derivatives trades go to central clearing, the world becomes more transparent – or at least theoretically simpler to manage. Eligible collateral at CCPs is a complicated topic, but at least there are relatively few CCPs and the rules are squarely in everyone’s face.
A link to the IFR article is here.