As mentioned in my first blog
on credit, typically a CSA will be put into place alongside an ISDA schedule.
There are a few key numbers and terms that go into a CSA which frame the main variables of the agreement - perhaps the most commonly discussed will be the:
- Frequency of the collateral calls
- Threshold amount
- Minimum Transfer Amount (MTA)
- Currency of the agreement
In recent times, equal if not greater scrutiny has come to be placed upon the constitution of the assets to be pledged as collateral, that is the "eligible collateral", and the ability of primarily the bank to 'rehypothecate' this collateral (which will be a key theme in my next piece).
Most modern CSAs contain an obligation to respond to a bank's call for collateral every business day, although some large clients do still operate with weekly or even monthly CSAs, usually for operational reasons. Clearly this is a key factor.
The threshold amount is the size of derivative portfolio mark-to-market that can exist before either counterparty is allowed to call for collateral, that is, how “out-of-the-money” a derivative portfolio can go before the other counterpart can scream for margin! This effectively frames the size of the uncollateralised risk that the bank is willing to take to the counterparty (and vice versa). Most modern CSAs contain low or even nil thresholds - and banks may often request (and sometimes even obtain!) asymmetrical thresholds, for example the bank may want to only start posting collateral when a MTM goes over $1million, while expecting the counterpart to post collateral on any move at all in their direction. This can be a particularly effective credit mitigant in the eyes of a bank, but as it exposes the underlying client to a potential $1million unsecured exposure to the bank, they may be much less keen on the arrangement!
The Minimum Transfer Amount is similar to the threshold. MTA is the minimum amount of additional collateral that can be called for. So if a threshold of $1million had been agreed with an MTA of $250,000, neither counterparty would be entitled to raise a call for collateral until the total mark-to-market of the derivative portfolio exceeded $1.25mio. This is largely for operational reasons, to prevent small amounts being called for each and every day without large MTM shifts occurring. In practice, any moderately sized derivative portfolio is likely to undergo MTM shifts of $250,000 or greater from day to day.
The total uncollateralised exposure that a bank will therefore have to a particular derivative counterparty at any time between collateral calls can be calculated by summing the threshold, the MTA, and the maximum daily (or weekly in the case of a weekly collateral call) move in the underlying derivative portfolio.
Although this is theoretically unlimited, most banks will use a statistical approximation to calculate the maximum likely daily shift in the value of the portfolio to arrive at this number. This, however is not the number that most banks focus on, because they are uncomfortable assuming that a client could be closed out of a large derivative portfolio (in the event of default) in a single day, so in practice most banks look at total credit exposure to a counterpart as the sum of the threshold, the MTA, and the maximum likely shift in MTM that could take place over (say) a 10 day period - i.e. assuming that it could take 2 weeks to fully close out the counterpart.
This is usually the way that banks view “credit line usage”, and therefore the longer dated a portfolio of derivatives is, and the less correlation between the positions in the portfolio, the higher the total credit line usage is likely to be.
[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer]