One of the many after-effects of the financial crisis is that derivatives dealers have changed their pricing practices to take account of Credit Support Annex (CSA) terms. Because collateral terms often vary from bank to bank, these changes are making it difficult for pension schemes to compare pricing among dealers, manage their counterparty exposures, and prepare for future central clearing requirements.
For these reasons, increasing numbers of UK pension schemes have been working to standardise their CSA’s across dealers and, when doing so, have found the prices dealers are quoting to make CSA changes to be high and variable. This short article outlines the rationale and key issues associated with standardising and simplifying collateral terms, explains why pricing among dealers is variable, and discusses the implications of these issues for pension schemes.
Dirty versus clean CSA’s
In the past, most UK pension scheme CSA’s permitted a range of collateral, including not only GBP cash and gilts but also non-GBP government and corporate bonds. This is often what is meant by a “dirty” CSA, whereas a “clean” CSA is defined as one that permits only GBP cash and UK gilts to be posted as collateral.
In the post-crisis world, there are a number of reasons that a scheme would want to move from dirty to clean CSA’s. First and foremost, standardising and simplifying CSA terms should result in more consistent pricing from dealers and this, in turn, should enable LDI managers to make more efficient cost/benefit assessments in their portfolio management activity, particularly when recouponing transactions and managing counterparty exposures. In addition, a clean CSA will bring a scheme in line with the central clearing requirements expected in 2015 under the new European Market Infrastructure Regulation (EMIR).
The following chart summarises the benefits and challenges of moving to clean CSA’s (click to enlarge).
While most pension schemes are going through a process of moving to clean CSA’s, they are finding it difficult to understand the economic cost or benefit of doing so because of the pricing variability that results from each dealer’s own assessment of the value of the terms.
Pricing variability among dealers
Pricing variability arises from a number of factors. Although LIBOR is still used to project the future cash flows of swaps, it is no longer used to discount these cash flows for valuation purposes. In the post-crisis funding environment, dealers have moved towards valuing swaps at the collateral financing rate – a rate more akin to the overnight rate, such as SONIA, rather than a three or six month rate, such as LIBOR. For swaps that have clean CSA’s (ie, CSA’s that only permit gilts and GBP cash to be posted as collateral), market consensus is that SONIA is the appropriate discount rate.
As a side note, clean CSA’s add a layer of complexity to ongoing valuation that did not exist in the pre-crisis world when LIBOR was used both to project and discount a swap’s cash flows. Because the LIBOR curve is only used to project the cash flows, and SONIA to discount them under a clean CSA, dealers now factor into their pricing assessments the difference between the two curves, known as the “LIBOR SONIA basis”. In periods of distress over the past few years, this basis has been volatile, as shown in the following chart (click to enlarge). Note the stability of this basis pre-crisis.
While the market agrees that SONIA is the appropriate valuation rate for swaps with clean CSA’s, there is less consensus on what the appropriate valuation rate should be for dirty, multi-currency CSA’s. Dirty CSA’s, by their nature, provide both pension schemes and dealers with more flexibility when posting collateral, but pension schemes may not place much value on having the option to post a wide range of collateral given the composition of their respective collateral pools and given that their assets are funded. However, dealers will often assign a higher value to this flexibility, because they have more varied sources of collateral and have established FX and repo desks to raise funds in multiple currencies, all of which enables them to monetise the flexibility that dirty CSA’s provide. For example, valuation rates for CSA’s that permit corporate bond collateral are often driven by corporate bond repo rates and non-GBP collateral by the cross currency basis swap rates. While there has been considerable discussion among market participants on multi-currency CSA’s, there is no consensus position on how multi-currency CSA’s should be valued, resulting in valuation differences between both sides under dirty CSA’s.
These valuation issues become even more pronounced with swaps that have high mark-to-market values, as more collateral is being posted and having to be funded. For example, a transaction that has a large mark-to-market value is now effectively priced as a derivative with a collateral funding requirement attached. The larger and longer the mark-to-market, the more the valuation is skewed by the choice of collateral component. This is what is known as funding delta, and the below table illustrates how it arises for a range of swaps with different tenors and mark-to-market profiles (click to enlarge).
The challenge that the above factors create for pension schemes is that, in the absence of a consistent framework, agreeing valuations with dealing counterparties and ensuring that collateral is being held to the true market value of a transaction is difficult. Moreover, in the event that dirty and clean CSA pricing were to diverge further due to moves in funding curves, most pension trustees are currently not set up to assess and manage this risk.
The arguments, therefore, for moving to a clean CSA are sound. And an element of urgency is added with central clearing on the horizon. Even if a scheme elects to use the three year exemption before moving to central clearing, continuing to implement transactions under a dirty CSA is simply adding to an existing problem that ultimately will need to be unwound.
Dealers, however, are asking pension schemes to pay up to change a CSA even though the swap’s cash flows remain the same and the factors driving pricing are not transparent and often vary from dealer to dealer. While traditional best practice among LDI managers was to take the cheapest price for entering into a swap, market participants are now considering both the “day one” price and the potential margin to move to clean CSA terms in the future.
For these reasons, it is important to understand the factors driving the prices being quoted to move to clean CSA’s. While there is no magic formula for reducing the costs that dealers are charging, most pension schemes, once they have made the decision to change, often view these charges as a cost worth bearing. That said, there will invariably be opportunities within each scheme’s particular circumstance to potentially reduce costs. For example, some dealers are opportunistically offering to lower their charges for CSA changes in exchange for more favourable terms in the swap documentation, such as lower downgrade triggers in any ATE’s that may exist. It is for this reason, most schemes are using advisors to help them navigate the process of cleaning up their CSA’s. And in the right hands and with the right guidance, the process need not be confusing or expensive.
Please note that Kenny Nicoll at Redington co-authored this blog with me.