February 3, 2017

OTC Counterparty Risk Mitigation Strategies

WHY ISDA AGREEMENTS ARE ONE-SIDED, AND HOW IT CAN AFFECT YOUR COMPANY

It should come as no surprise that the International Swap Dealer Agreements (ISDA) today’s multinational corporations sign with banks tend to be one-sided. If the bank defaults on a corporate customer (think Lehman Brothers), there’s no opportunity to collect on collateral. All of this may work well for the banks, but not so well for your company. This paper looks at some of the problems associated with over-the-counter trading, and specifically how it relates to counterparty risk mitigation.

ISDA Review

A critical component to any over-the-counter (OTC) trading relationship is your ISDA agreement, specifically the schedule to your master agreement and your Credit Support Annex (CSA). As many corporate financial professionals know, an ISDA agreement is the cornerstone of any transactional relationship between two parties engaged in OTC financial transactions. An ISDA agreement is composed of three major components:

  1. Master Agreement – Standard language shared among all parties to execute ISDA agreements.
  2. Schedule to the Master Agreement – The terms that have been negotiated between the two parties thatspecifically contrast what’s been outlined in the Master Agreement; or language that potentiallyenhances understanding of, or further modifies, the Master Agreement.
  3. The Credit Support Annex (CSA) – This is the third and separately negotiated piece of documentation that outlines what would happen to address credit risk that the counterparties have to each other. For example, it may be a common practice in your CSA to have the posting of collateral to the extent that either of the parties is downgraded by a nationally recognized rating agency; or, if there’s some type of default event, technical fault or actual default, that could result in additional collateral posted by either counterparty.

hedging currency exposureFigure 1 illustrates how a Credit Support Annex might work. The company in the upper left has just been downgraded to a “BB+” rating from “investment grade,” and the banking counterparty notifies them that a) they’ve violated the terms of their CSA and b) they need to post additional collateral, because the trade – or the net of all their trades they have outstanding with this counterparty – is out of the money.

The key thing to notice in Figure 1 is that the bank has ISDA agreements with all the participants, whereas individual companies typically only have an ISDA agreement with the bank, or potentially multiple banking counterparties. Individual companies don’t have nearly as many ISDA agreements as the banking counterparty has with other commercial clients.

financial counterparty distressFigure 2 illustrates what we’ve seen happen over the last couple of years. Our banking counterparty example in the middle is Lehman Brothers, which moved from a “Mid A” credit rating to basically going bankrupt over the weekend. There was no opportunity for the commercial counterparties to demand collateral from them, and they probably wouldn’t have received it. In fact, when Lehman went under, they had over 8,000 master ISDA agreements signed and over 67,000 open trades.

This is the state of ISDA agreements as they exist today. A typical CSA may call for the exchange of collateral at a level of “BBB” or lower. This results in a one-sidedbenefit for the bank, with no practical benefit for the commercial counterparty. A commercial counterparty may be able to operate just fine with a BBB rating, or even in an environment below “investment-grade” for quite some time, giving the bank ample opportunity to receive collateral under a typical existing CSA.

Conversely, a change in a major bank’s credit rating to the same level would be a proverbial nail in their coffin. Sufficient capital would have already left the bank, and the bank’s cost of funds would have already increased to a level that would make operating as a bank impossible. So as they exist today, CSA’s only provide a false sense of security to the commercial counterparty.

What your company can do to help protect itself?

Companies have largely taken two different approaches to correct for what they see as one-sided CSAs that favor the financial counterparty: using third-party collateral managers, and trading on a listed futures exchange.

Many companies arrange for third-party collateral managers to accept and remit collateral –

based on the market-to-market status of the outstanding trades – to each financial counterparty. While the daily posting of collateral tends to be the most effective way to ensure the credit worthiness of your OTC counterparty, it tends to be very cumbersome for both the commercial and the banking counterparty.

“Re-hypothecation”

Beyond the operational complications of posting collateral on a daily basis, arrangements with the third-party collateral manager can become further complicated due to a practice known as “re-hypothecation” illustrated in Figure 3.

re-hypothecation

In this example, Party A is out of the money on a trade, or a series of trades, to Party B, and is therefore required at the end of the day to post the collateral. In this example, Party B is the commercial counterparty, which actually has no net position in this particular transaction due to the fact that it has an equal andoffsetting trade to counterparty C. So while Party A is out of the money to Party B, Party B is also out of the money to Party C. Party B therefore passes on the collateral that it received from Party A to Party C, i.e. Party B has “re-hypothecated” Party A’s collateral.

Where this situation gets even more interesting is when Party C goes bankrupt, and Party B is left to deliver a termination notice to Party C. Party B is essentially forced to re-issue the equal and offsetting trade that it had to counterparty A.

Disclaimer

The information contained in this publication is provided for information purposes only. The information contained herein has been obtained or derived from public sources believed to be reliable, but we do not represent that it is accurate or complete and should not be relied upon as such.Any opinions or predictions constitute our judgment as of the date of this publication and are subject to change without notice.

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© 2017 Atlas Risk Advisory LLC

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