Coming back to the CSA for a moment, one of the most important factors to be agreed in a CSA and one which often escapes high level scrutiny but which can dominate negotiation is the eligible collateral – that is to say, the assets which are eligible to be posted as collateral under the agreement.
There are several key factors which will be considered by the bank, which can usually be separated into one of three camps:
- how easy it is to accurately value the collateral
- how easy it is to liquidate in the event of a default (these two are usually closed correlated, depending on the liquidity of the underlying asset)
- whether the collateral can be rehypothecated - that is, whether it can be re-used by being posted on to another derivative counterparty.
Clearly the best collateral is cash, as it does not need to be liquidated in the event of a default, needs no complicated valuation methods, and can always be rehypothecated. Coming close after cash are the most liquid government bonds, like US Treasuries, German Bunds and UK Gilts (although these are less liquid than their US and German equivalents). Typical interbank (that is, agreements which are put in place between large banking groups) CSAs will therefore consider only cash and highly rated Government debt, usually denominated only in GBP, EUR or USD.
When it comes to clients, however, flexibility is the name of the game and many clients like to widen the scope of what they can post, and perhaps limit the scope of what collateral they might receive. A UK Building Society for example may have no way of making use of US Dollar denominated cash, so may wish to limit the collateral in its agreement to being Sterling denominated. Another example is that there are many pension funds and insurance counterparties who would like to be able to use their corporate bond portfolios as collateral.
Once upon a time this was relatively common practice, and banks were generally been able to get comfortable with high rated corporate bond portfolios, subject to some limitations on concentration risk and appropriate haircuts, but this has been much more limited since the Credit Crunch. Haircuts and concentration limits need not just apply to corporate bonds, however, as both terms function as mitigants with regards to the ability to liquidate in the event of a default - the bank needs to be able to sell the asset above the level that it has haircut it to, in order to avoid taking a loss. These days it is common for even high quality collateral to be subject to some sort of haircut, particularly on long-dated Gilts.
Ultimately, any asset could be suitable for use as collateral, but it is important to make sure that the assets are being valued correctly and appropriate limits and haircuts are in place to ensure losses are avoided in the event of default. Many people will have read the stories about the various forms of “dodgy” collateral that was being posted by Lehman in its last few days, and I certainly know of a handful of clients who woke up on Monday September 15th 2008 to discover that some of the collateral received from Lehman wasn’t worth the paper it was printed upon. This is just one of the many reasons why many regulators favour a move towards Central Clearing Houses (CCHs) for the central valuation of derivatives and collateral.
In recent years a much larger focus has come onto the ability to rehypothecate collateral and this is where expanded collateral eligibility can be more challenging. Consider for example the case of the London Clearing House, which many large banks now clear their derivatives through and which only accepts cash collateral. A bank which takes corporate debt as collateral from a pension fund, but then needs to post cash to the clearing house, needs to repo the corporate debt, probably on a daily basis, in order to obtain the required cash, or fund the cash collateral from elsewhere in its business. I know of one fund manager that has been unable to secure an agreement to post corporate bonds from its newest funds to support the derivative portfolios, and therefore will have to make a choice between setting up a repo operation to turn those corporate bonds into cash, or holding more cash or Government bonds in the funds than it might otherwise like.
This is a theme which is likely to continue to play out as we move closer towards centrally cleared derivatives.
[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]