©2011-2012 International Swaps and Derivatives Association, Inc.ISDA® is a registered trademark of the International Swaps and Derivatives Association, Inc.

A Short Introduction to theStandard Credit Support Annex

Michael ClarkeManaging Director

Goldman, Sachs & Co.

Collateral in circulationCollateral in circulation

• $2.9 trillion collateral in circulation for derivatives

• >150,000 agreements

• Many examples of effective loss mitigation during credit events since 1996

2

Source : ISDA Margin Survey 2011 and earlier years

Volume of Collateral in US$ billions

(Bars)

Collateral Agreements

(Line)

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Issue 1 - Embedded optionalityIssue 1 - Embedded optionality

• The CSA permits:

Delivering Party choice of collateral asset from the list of Eligible Collateral

Delivering Party ability to substitute collateral

Receiving Party consent for substitutions under English Law CSAs (to reduce re-characterization risk)

• These are options and have economic value.

How can we project their future value?

How can they be priced?

Extreme pricing complexity

Impossible to hedge

“The CSA is the most exotic of exotic derivatives”

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Issue 2 - Embedded funding mismatchIssue 2 - Embedded funding mismatch

• The CSA takes the mark-to-market exposure of many transactions in different currencies, nets them, and requires collateral to cover that amount (ignoring Thresholds, MTAs and IA).

• In most cases, the collateral is delivered in a single currency, often USD or EUR.

• Interest accrues at the overnight index rate for the relevant currency of the collateral actually delivered, e.g. Fed Funds or EONIA.

• This creates a mismatch in funding currency and interest accrual between the underlying derivative cashflows and the collateral.

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Aligning collateral and swap cashflowsAligning collateral and swap cashflows

• Consider a swap with a single cashflow of $10 in one year...

5

• Under the SCSA collateral is required to cover the mark-to-market value of the swap, so $9 of collateral is delivered today.

• Under the SCSA collateral must be cash in the currency of the swap, and cash collateral earns interest at the OIS rate.

• Therefore $9 of collateral delivered today earns interest of $1 over the next year. When it is returned at the end of the swap, the collateral plus interest will precisely cover the $10 cashflow due - with no currency risk and no basis risk.

• If properly aligned, the collateral funds the future swap cashflow.

Time

FV = $10

PV = $9

Discount rate i = OIS

Today + 1 Year

PV = (1+i)n

FV

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Example: Economics of mis-alignmentExample: Economics of mis-alignment

6

×

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1. Accruals by Currency Silo

Undisputed Amount (in currency)

Spot FX RateNet Undisputed

Amount (in Transport Currency)

Collateral Actually Delivered under CSA

Implied FundingRate Index

Implied Funding

Rate

Implied AnnualFunding Cost

USD Equivalent for Comparison

USD 8,000,000 1.00000 8,000,000 n/a Fed Funds H-15 0.0800%

USD 6,400 USD 6,400

EUR 100,000,000 1.44102 144,102,400 n/a EONIA 1.0710% EUR 1,071,000 USD 1,543,337

JPY (5,000,000) 0.01000 (50,000) n/a Mutan Call 0.5601% JPY (28,005) USD (280)

GBP (6,000,000) 1.61000 (9,660,000) n/a SONIA 0.0950% GBP (5,700) USD (9,177)

CHF (2,000,000) 1.16000 (2,320,000) n/a TOIS 0.0210% CHF (420) USD (487)

Total: 140,072,400 Total: USD 1,549,737

2. Accrual for Transport Currency If Held Unconverted

Net Undisputed

Amount (in Transport Currency)

Collateral Actually Delivered under CSA

Actual FundingRate Index if Held in Transport Currency

Actual FundingRate

Actual AnnualFunding Cost

USD Equivalent for Comparison

Portfolio 140,072,400 140,072,400 Fed Funds H-15 0.08% USD 112,058 USD 112,058

Issue 3 - Impediments to risk transferIssue 3 - Impediments to risk transfer

• There is an active market in derivative novation and assignment. In addition, regulators and market participants are encouraging the transfer of bilateral risk to CCPs where possible.

• The LIBOR-OIS discounting issue discussed earlier makes these risk transfers more difficult, because of the differences in choice of underlying curve.

• The collateral-related effects render these risk transfers even more difficult, since CSA terms are not consistent across the market, and the two parties to a given CSA may factor the collateral terms into pricing differently (if at all).

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Issue 4 - Lack of standardizationIssue 4 - Lack of standardization

• The inherent flexibility of the CSA is a major positive in that the vast majority of the exceedingly wide universe of derivatives executed with the entire spectrum of credit quality counterparties can be collateralized under a CSA.

• However, regulatory perception is that not all variations under the CSA are warranted; or put another way, standardizing some terms to reduce the number of variations would not harm the market.

• Focus on eligible collateral, Thresholds, MTAs and IA.

• Operational procedures and market standards are in fact very consistent across market participants.

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How the SCSA works: ContextHow the SCSA works: Context

9

PARTY X PARTY Y

Portfolio of executed transactions between two counterparties

Transactions clearable when executed

Transactions not clearable when executed

Clearing House1

Clearing House2

Clearing House3

Clearing House4

Clearing House5

Clearing House…n…

Each clearing house has its own unique margin rules

CSA(Legacy Trades)

SCSA(New trades)

One net collateral

requirement each day,

delivered in eligible

collateral of choice

One collateral requirement per currency each

day, delivered in each currency or

converted to a single currency with an interest

adjustment overlay.

Netting Set maintained across full Master Agreement scope and all

collateral.

Trades may be moved from the CSA to the SCSA (but not vice versa).

See over for detailed mechanics

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How the SCSA works: MechanicsHow the SCSA works: Mechanics

10

Designated Collateral Currency (DCC) Silos

PARTY X PARTY Y

PARTY X PERSPECTIVE:

PARTY X

EUR Transactions GBP Transactions CHF Transactions JPY Transactions

EUR GBP CHF JPY

All Transactions

Pro FormaCurrent CSA for

Comparison

INCLUDEDTRANSACTIONS (See next page for cross-currency transactions and non-G5 single currency transactions)

USD

EXPOSURE ∑MTMUSD ∑MTMEUR ∑MTMGBP ∑MTMCHF ∑MTMJPY

COLLATERAL ∑CASHUSD ∑CASHEUR ∑CASHGBP ∑CASHCHF ∑CASHJPY

REQUIREDSETTLEMENTThreshold = 0

MTA = 0

∑CASHUSD ∑CASHEUR ∑CASHGBP ∑CASHCHF ∑CASHJPY

∑MTMALL

∑CASHALL +∑SECURITIESALL

∑MTMUSD ∑MTMEUR ∑MTMGBP ∑MTMCHF ∑MTMJPY

- - - - -∑MTMALL

∑CASHALL +∑SECURITIESALL

-

OR

ORSAFE SETTLEMENT (PVP OR ESCROW) PLATFORMOR COMMON ARBITRAGE-FREE IMPLIED SWAP ADJUSTMENT MODEL

OR

PARTY Y MIRROR IMAGE PARTY Y PERSPECTIVE

Herstatt Risk

Elimination

THRESHOLD

-

USD Transactions

OR OR OR OR

OR OR OR OR

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Silo (DCC) and Transport (CSC) CurrenciesSilo (DCC) and Transport (CSC) Currencies

11

Designated Collateral Currencies (“Silos”)

Convert to a Collateral Settlement Currency(“Transport Currency”) and Net

Settle the Net Transport Currency Amount

Re-convert to Silo currencies

1

2

3

4

USD EUR JPY GBP CHF ..etc.. G17

Compute and pay interest at OIS on Silo balances of collateral5

USD EUR JPY GBP CHF ..etc.. G17

Req

uir

ed b

yth

e S

CS

A +

IS

AR

equ

ired

by

the

SC

SA

+ I

SA

Det

erm

ined

by

firm

-sp

ecif

ic A

LM

co

nsi

der

atio

ns,

no

t th

e S

CS

A

49

Receiving party has a choiceReceiving party has a choice

12

• There is no SCSA requirement for the party receiving the net amount of Transport currency to do anything in particular with it….

• BUT… it is fully rehypothecable and each party has the obligation to pay interest at OIS for each silo Undisputed Amount

• Which implies two important actions for the parties…

PARTY X PARTY YUSD 140,072,400

Collateral Amount Physically Moved

PARTY X PARTY Y

Interest Obligations

EUR 1,071,000

JPY (28,005)

GBP (5,700)

CHF (420)

USD 6,400

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Balances must be manufacturedBalances must be manufactured

13

• The actual physical movement was USD 140,072,400.

• The implied DCC silo balances were however…

• So Party X has to establish balances of EUR 100mm and USD 8mm on which to accrue interest it will pay.

This is more than the physical movement received.

• Party Y has to do the same for JPY 5mm, CHF 2mm and GBP 6mm.

This is more than the physical movement received (which was nothing, because Y delivered to X of course).

PARTY X PARTY Y

Implied Silo Balances

EUR 100mm

JPY 5mm

GBP 6mm

CHF 2mm

USD 8mm

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Integration into treasury managementIntegration into treasury management

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• Balance sheet obligations for the individual DCC balances need to be established, so that correct accruals can occur.

• The actual physical movement of USD 140,072,400 also needs to be addressed. It needs to be funded by Party Y and invested by Party X.

• It must therefore be integrated into the treasury management processes at the two firms.

• The receiver of the physical movement will need to consider:

Converting the received transport currency amount into the relevant DCC silo balances - a direct hedge of the funding risk.

Factor the received transport currency amount into the general treasury funding flows for the day - a portfolio hedge of the funding risk.

Leave the collateral in the transport currency and do not hedge.

• We do not recommend the last option.

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Baseline funding and collateral flowsBaseline funding and collateral flows

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PARTY X PARTY Y1

9

EUR 100mm

EUR 100mm

EONIA

6

8

EUR 100mm

2EUR 100mm

EONIA

5

Collateral Flows

Party Y

Fu

nd

ing

Trad

e

3

7

EUR 100mm

EUR 100mm

EONIA

4

Party X

Fu

nd

ing

Trad

e

Net Interest Zero Net Interest Zero

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Netted settlement collateral flows Netted settlement collateral flows (EUR silo only)(EUR silo only)

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PARTY X PARTY Y1

13

USD 144,102,400

USD 144,102,400

Fed Funds

10

12

USD 144,100,000

2USD 144,102,400

EONIA

3USD 144,102,400

4EUR 100,000,000

USD 144,100,000

EUR 100,000,000

8

7

9

EU

R 1

00,0

00,0

00

5

EU

R 1

00,0

00,0

00

611

EO

NIA

Collateral Flows

Party Y

Fu

nd

ing

Trad

e

To

m/N

ext Sw

ap

Party X Funding Trade

Basis Difference

Cash Difference

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Receive EONIA 3,635Pay Fed Funds (1,001)Cash Difference (2,400)

Net 234(Cross-currency basis)

EconomicsEconomics

17

PARTY X PARTY Y

Receive EONIA 3,635Pay EONIA (3,635)

Net Zero

56

Cross Currency BasisCross Currency Basis

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• Cross-currency basis refers to the spread adjustment required on one leg of a Libor vs. floating cross-currency swap in order to make the swap price at par.

• This basis is observable in the market (see Bloomberg or Reuters swap rate screens).

• There is a no-arbitrage relation between FX forwards, interest rate swap levels, and cross-currency basis.

• Two streams of par cashflows in different currencies may have a zero present value when considered each in isolation, but when linked via a transaction the net value is non-zero; the difference is the cross-currency basis and reflects the differences in perceived credit risk and market access between the parties funding in the two currencies.

• Cross-currency basis may be positive or negative.

• The ISA methodology implicitly includes the cross-currency bases for all silos.

• One can consider the $234 cross-currency basis as the “cost” of using net settlement (the ISA methodology) to eliminate Herstatt risk and compare it to the cost of constructing alternative methods of managing this risk (eg building a PVP platform).

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SCSA program planSCSA program plan As of February 28, 2012 - subject to change

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Q4 2011 Q1 2012 Q2 2012 Q3 2012 Q4 2012 Q1 2013

Phase 1Live Date August 10

PVP Requirement Definition

PVP InfraConstruction and Testing

FPML Design

Phase 1 - Pathfinder Implementation for Volunteer Firms

(Timings are highly uncertain)Phase 2 - Wider Market AdoptionTiming for PVP delivery is highly

uncertain at this time and dependent on third party

construction. Historical examples of linked-settlement infrastructure have shown that construction can

take many years.

Counsel Review

1. Commercial Design Stream

2. Legal Stream

3. FPML Stream

4. InfrastructureStream

6. ExecutionStream Adoption

DesignExecution

Test Prep

Continued Business Technical Input

Local Counsel Opinion Updates

JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV DEC

Arrows illustrate certain key dependencies

NOW

7. Education and Regulatory Outreach Stream

MarketEducation

Regulatory Outreach

MarketEducation

5. ISDA SCSAFIXStream

Design

MarketTesting

Design

Infra Spec

Legal Doc Drafting

CommercialDesign

Program critical path is outlined in blue

InternalIT Change

ISDAFix SCSA Build

Market Infra Development

ISA Details

MarketEducation

Bilateral pairs of firms may execute the SCSA at any

time after August 10

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Advantages of the SCSAAdvantages of the SCSA• Removes collateral “switch options”

• Restricts variation margin to cash only, so that collateral interest accruals will approximate the funding cost of the underlying cashflows.

Further limits this to cash for which a liquid OIS market exists.

Will be extensible as other OIS markets develop liquidity, promoting the growth of liquid OIS markets.

• Simplifies calculations by standardizing terms.

• Eliminates structural CSA differences, thus:

Trade valuation more consistent and transparent.

Making novation, assignment and risk transfer to CCPs easier.

Reducing one cause of margin disputes.

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