XVA. Green Andrew

have now started to receive payments (Rushton, 2014).

      2.4 Credit Risk Mitigants

      There are a number of ways of reducing counterparty credit risk and these can be placed into six categories; netting, collateral/security, clearing, capital, break clauses and purchasing credit protection.

      2.4.1 Netting

A close-out netting agreement provides the legal framework for assets and liabilities to be netted together when closing out a portfolio of derivatives in the event of a default of one of the counterparties. Close-out netting significantly reduces credit exposure, with research by ISDA suggesting a reduction of 85 % (Mengle, 2010). To see how this works consider the following example where A and B have two derivatives transactions between them, one with a value of £1m and the second with a value of −£0.5m as seen by A. B then defaults and A recovers 40 % of the claim value. If the two derivatives net then the credit exposure at default is £0.5m and A will recover £0.2m, a net loss of £0.3m. However, if the trades do not net each trade will be treated separately with A recovering £0.4m on the trade with a value of £1m but having to pay £0.5m back to the administrators of B on the second transaction with a negative value. A’s net position is −£0.1m with no netting, a net loss of £0.6m. This is illustrated in Figure 2.2.

Figure 2.2 The impact of close-out netting reducing overall credit exposure.

      Netting is enshrined in the ISDA Master Agreement which is the bilateral agreement between counterparties that provides the legal framework for OTC derivative trading. Netting is enshrined in English law but in some other jurisdictions separate legislation has been needed to allow close-out netting to be implemented. The legal enforceability of netting remains a concern for market participants and the use of netting has faced challenges in the aftermath of the 2008 financial crisis (Mengle, 2010).

      2.4.2 Collateral/Security

      Credit risk can be mitigated or eliminated entirely if the counterparty provides some form of security to cover the value of the liability which will be returned when the liability is repaid. Examples of this type of secured transaction are repos and reverse repos. A repo or repurchase agreement is a trade in which one counterparty sells bonds to another counterparty and agrees to repurchase them at a fixed price at an agreed date in the future.16 Repo transactions are a type of secured lending. If the bonds decline in value during the period of the repo additional collateral must be supplied, either more of the same bond, a higher quality bond, or cash.

       Figure 2.3 The repo/reverse repo transaction flows.

      Derivative transactions can also be collateralised in a similar way to repos through a CSA or Credit Support Annex agreement. CSAs provide the terms of a bilateral agreement between two counterparties that allows for collateral to be posted between them to secure the derivative. The CSA is an annex to the ISDA Master Agreement between the two parties. Standard ISDA and CSA agreements are provided by the International Swaps and Derivatives Association Inc., although in practice all ISDAs and CSAs contain some variation in terms and conditions and this has recently prompted ISDA to propose a standard CSA agreement (ISDA, 2011). There are two main versions of the ISDA master agreements, known by their publication dates in 1992 and 2002, respectively, and these will be discussed in more detail in Chapter 3. The settlement conditions embodied in these documents do have an impact on recovery rates.

Derivatives can have both positive and negative mark-to-market values. Hence, most CSA agreements provide support for both counterparties to post collateral, if required, during the lifetime of the transaction or portfolio of transactions if a netting agreement is in place. There are a number of key parameters associated with CSA agreements that control the amount and timing of collateral postings and these are described in Table 2.1. CSA agreements significantly reduce counterparty credit risk but do not eliminate it entirely. The risk is reduced, however, to the discrepancy between the value of the derivatives and the value of the collateral at the time default is recognised. In practice there will be a period between the date on which the last collateral is received and the date when the position is closed, even if the call frequency is daily. Both derivative and collateral value could vary in this period. Care must also be taken if there is a relationship between the counterparty and the collateral that is posted. If there is an adverse relationship this could lead to significant wrong-way risk in which the counterparty defaults and the value of the collateral declines sharply. One significant feature of most CSA agreements is that the collateral can be rehypothecated or reused by passing on to other parties in support of other CSA agreements.17

Table 2.1 Key CSA parameters.

      In some transaction types such as those linked to commercial real estate or project finance the derivatives form part of a financing package that includes loans and other facilities. Frequently these transactions are secured on an asset such as, for example, a building or railway rolling stock in the case of train leasing transactions. In these cases, should the counterparty default then the derivative originator will be able to claim the assets used to secure the financing. Security thus acts in a similar fashion to financial collateral under a CSA, although it is not rehypothecable in most cases. Unlike a CSA, however, no further margin call can be made so a risk of loss will occur if the value of the financing package exceeds that of the security.

      The security itself may also vary in value, so commercial real estate may lose value in an economic recession. For example, consider a shopping mall provided as security against a loan. If the shopping mall performs well then all of the shops will be rented and the shopping mall owner will have no difficulties paying off the loan. If, however, the shopping mall performs badly with many unrented shops and worse than expected income the shopping mall owner may face difficulty making payment on the loan. If the shopping mall owner defaults then the bank will receive an asset which is already under performing.

      The asset may secure more than one set of financing transactions or the package itself may be syndicated among a number of banks leading to additional complexity.

      2.4.3 Central Clearing and Margin

       Central Counterparties or CCPs have been seen by regulators as a means of reducing counterparty credit risk in the aftermath of the 2008 credit crisis.18 In reality CCPs have been a feature of the market for many years in the guise of clearing houses associated with exchanges. The London Clearing House,19 for example, was formed in 1888 to clear commodities contracts and started clearing financial futures for London International Financial Futures Exchange (LIFFE) in 1982. CCPs now provide clearing for standardised derivative contracts such as interest rate swaps and credit default swaps and in 2009 the G20 leaders mandated that all standardised OTC derivative contracts be cleared by the end of 2012 (Financial Stability Board, 2010). While regulators and world leaders have seen CCPs as critical to reducing system market risks (G20, 2009), others have suggested that CCPs themselves lead to systemic risks (Duffie and Zhu, 2011; Kenyon and Green, 2013c).

      Central clearing operates in much the same way as a bilateral CSA contract in that collateral must be supplied to support the movements in the mark-to-market of the portfolio of derivatives. This collateral is known as variation margin in the context of clearing. The frequency of calls for variation margin is typically daily. The rules of individual CCPs vary but considering LCH.Clearnet SwapClear as an example, three additional elements of margining are present: initial margin, liquidity multipliers and default fund. The initial margin is similar to initial margin in CSA agreements in that it must

19

Now called LCH.Clearnet following the merger of the London Clearing House with the French Clearnet in 2003 (LCH, 2012c).